During the recovery from the 1990’s recession, a lot of outrage was aimed at the fact that when a company announced lay-offs the stock market indexes went up; this appears to be a trend we have seen recently. But, if rising unemployment rates are a bad thing for the economy, why are stock indexes going up?
At its very core, unemployment rates and stock market indexes are lagging and leading economic indicators respectively. A lagging economic indicator is a snapshot of the past and may not be necessarily reflective of the here and now. For example, businesses tend to engage in massive lay-offs after the financial results are in for the previous quarter; management may have a feeling it is doing properly but until the bean-counters consolidate the financial statements, it is a feeling only. Thus, a lagging indicator tends to merely validate past events.
A leading economic indicator estimates future economic activity. Stock indexes are basically a measure of future expectation of profit. Building permits issued are indicators of potential upcoming real estate activity (there is a difference between an issued permits and a built permits; the former predicts the future, the latter measures the past- if you are a real estate investor, look for built permits not issued permits when conducting your due diligence; it is a truer measure of real estate activity). Leading indicators, because of their speculative nature, tend not to be accurate all the time so take leading indicators with a grain of salt.
Thus, you are not actually measuring apples to apples when you look at unemployment rates and stock market indexes. One looks back, the other forward.
However, more specifically, why do stock markets react positively to rising unemployment numbers? The answer may be two-fold. First, massive spikes in unemployment may signal a quick descent to the bottom and an imminent recovery, meaning a quick bounce back in stock prices. Second, from a quantitative perspective, lay-offs mean lower expenses which means a company can maintain the same level of business but make greater profits.
Both factors, despite a certain cold-heartedness to the analysis, tend to warm the hearts of traders who take this as a sign things will get better for the economic performance of a stock (although not necessarily for the common working person on unemployment insurance).
If you subscribe to the theory that the worse of the credit crisis is over and we are entering into a plain-old recession (a hunch to be sure in such unpredictable times), one factor to look for to validate this theory is to see if we are going to see the early 90’s behavior again of a parallel rise in unemployment rates and stock market indexes. A long and sustained rise in unemployment rates accompanied by a long and sustained fall in stock market indexes (think years for both) may validate the depression theorist out there. It may take the rest of 2009 and early 2010 for anyone to call it.
Have a safe and fun long weekend.
April 9th, 2009 at 8:23 am
Great job breaking down a confusing trend, so that even people who are inexperienced with the stock market (me) get the message!
April 15th, 2009 at 4:00 am
I always found stock markets to have the best predictive values versus economy or economists. In general job cuts are good for the company as it cuts expenses. But typically the effects of these jobs cuts would be felt 2-3 quarters after the event since there are severance benefits that companies pay to the fired workers.
But if I were to exercise my critical thinking, more layoffs means less consumers willing to purchase more products, which means less revenues and lower profits, which means more layoffs.. Ouch,my head is spinning now
April 15th, 2009 at 10:03 am
Dividend Growth Investor- it will be interesting to see what happens this time around. In the 1990’s, the American economy was more export driven (and the trade imbalances smaller) so it could lay off domestic employees (remember when outsourcing first became popular?) but get the world to consume more. In a global economy, who knows what will happen? Other than the fact the economists will probably get it wrong!