Unemployment and inflation – key economic indicators.
The unemployment rate is a key indicator of the health of any economy. A high unemployment rate indicates that the economy is not producing enough jobs – prolonged states of high unemployment erode purchasing power, drag down productivity, and eventually affect the physical and mental health of a workforce.
In contrast, a low unemployment rate indicates that the economy is doing well. This is reflected in the stock market, as investors are more likely to invest in companies that are thriving.
So how much can the unemployment rate determine stock prices, and how does that prediction affect particular stocks? Is there a link? Keep reading to learn more about the above topics in much more detail, including the relationship between unemployment, stock prices, inflation, and the economy.
Does the Unemployment Rate Forecast Stock Prices?
The unemployment rate can signal a healthy (or unhealthy) economy. Therefore, it can forecast stock prices to a certain degree. The more people are out of work, the less demand there will be for a company’s services and products, so stock prices fall. Investors like to invest in companies in profitable businesses within stable economies, so their investing activity drops off when indicators (such as unemployment) show threats to profitability.
If the unemployment rate is high, this prompts action from the Federal Reserve, including lowering of interest rates and open market asset purchases. When the Fed decreases interest rates on borrowers and businesses, its goal is to lower the unemployment rate. Lower interest rates encourage people to borrow and spend money, which boosts demand for products and services, and hence, creates more jobs.
If the unemployment rate is low, this signals a healthy and vibrant economy. A healthy economy prompts investors to purchase assets, as they assume demand will increase. The Federal Reserve will remain hands-off as long as the growth continues at a steady pace.
Whether for good or for ill, the unemployment rate impacts stock prices due to the Federal Reserve’s involvement in the stock market’s preservation. Here are the two main ways the Federal Reserve is involved in the stock market.
This is the interest rates banks charge each other to borrow and lend money overnight. Raising this rate makes it easier or harder to borrow money, depending on whether the Fed raises or lowers rates. When it is harder to borrow money, interest rates rise and economic growth is suppressed. Companies then will lower their growth estimates, making investors less interested in buying their stock because risk has increased. As a result, the market as a whole will decline.
For example, if an investor expects a 9% return on their money but the company says they expect future growth of 4%, the investor is better off investing in a less risky investment, possibly bonds.
The same is true with the opposite. If the federal funds rate is lowered, it will be easier to borrow money. Companies can grow faster in this environment because there is cheap money to borrow to fund future growth. As a result, the stock market will rise.
The other way the Federal Reserve impacts the stock market (albeit indirectly) is through asset purchases. This is also called quantitative easing or tapering. In this scenario, the Federal Reserve purchases Treasury securities — a type of bond issued by the federal U.S. government.
When this happens, bond yields are lower since bond prices and yields are inverted. With the increased demand from the Fed buying these securities, their price rises and the interest rates go down.
With lower bond yields, companies can borrow money cheaply, allowing for faster growth. When the Fed stops buying these securities or sells them back into the market, bond prices will decrease and bond yields will increase, making it more expensive for companies to borrow money. The result is slower growth and a decline in stock prices.
How the Unemployment Rate is Calculated
The unemployment rate is the percentage of the total workforce that is unemployed and actively seeking work. This is calculated by taking the total number of unemployed individuals, dividing it by the number of people in the workforce, and multiplying it by 100.
Assuming there are 25,500,000 people unemployed and the whole workforce totals 330,500,000, the unemployment rate would be 7% (25,500,000 / 330,500,000) x 100 = 7%
When this rate increases or decreases, those actions affect the economy, as detailed above.
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Unemployment vs. The Stock Market
Unemployment rates can inform investors on the best time to buy stocks.
Historically, stock prices have increased when unemployment was low and decreased when unemployment was high.
However, that’s not all there is to it. The relationship between unemployment and the stock market is a complicated one. The correlation between the two is not always linear, and many factors influence this relationship.
One of these factors is inflation, which can lead to higher interest rates. Higher interest rates can lead to more expensive borrowing and lower stock demand.
This is true for all investors. For people trading on margin, they will see an increase in the margin interest rate they pay to borrow money to invest. With a higher interest rate, they will be less likely to borrow money because the return they need to achieve to earn a profit will be harder to attain since the market as a whole will slow.
Retail investors will be less likely to invest as well. This reason is two-fold. First, with a smaller return, people will put their money in other places, including in bonds or in savings accounts. Additionally, with higher borrowing costs, the interest rates on their credit cards, mortgages, and other debt will increase. If they are taking out an auto loan or mortgage, the interest rate will be higher, costing them more money every month. Many people will see more of their monthly income go towards debt repayment, decreasing what they can afford to invest in securities.
Unemployment vs. the S&P 500The unemployment rate and the price of the S&P 500 have a close inverse relationship, meaning when the unemployment rate goes down, the S&P goes up. When the unemployment rate goes up, stock prices go down.
However, this relationship doesn’t always happen at the same time, or over a prolonged period. If you simply look at annual charts, you may miss the correlation. Many times the S&P 500 will fall before unemployment peaks, and by the time of the peak, the market as a whole has already begun to head higher.
Look at 2020 as an example. If you look at the annual return of the S&P 500, you see the index gained 16% that year. However, unemployment rapidly increased due to the pandemic. As a result, the market dropped significantly.
In another example, from 2000 to 2002, the unemployment rate slowly increased each year. At the same time, the S&P 500 decreased.
Unemployment vs. NASDAQ
However, since the NASDAQ comprises more technology stocks, the impact of unemployment is magnified. This is due to the fact that tech stocks grow more aggressively, so a slowdown in the economy hurts these stocks more. Conversely, when the slowdown is over, the NASDAQ will see greater growth.
To illustrate this, during the recession from 2000 to 2002, the S&P 500 Index fell an average of 15% annually. The NASDAQ fell an average of 35% annually.
In the three years after the recession was over, the S&P 500 gained an average of 13% per year, while the NASDAQ grew an average of 20% per year.
Can Unemployment Rates Predict Stock Prices?Economic indicators can be classified into two main groups: leading indicators and lagging indicators. A leading indicator tells you economic trouble is coming. A lagging indicator tells you there was economic trouble, but only after the fact.
The stock market is a leading indicator, and because of this, stock prices will fall before a recession takes place.
Whether or not businesses have enough workers to earn profits and whether investors have enough money to continue to buy shares both influence the growth of the stock market.
This can be seen by looking back to times when unemployment was high. In 1982, inflation was over 13% and to get control of it, then Fed Chairman Paul Vockler began to aggressively raise interest rates up to 20%.
This aggressive action led to the unemployment rate increasing to 10%. With business growth slowing and demand from consumers waning because so many were unemployed, the stock market declined.
If you look at a chart of the market however, you will see that the S&P 500 Index was up 14% in 1982. This is because the market is a leading indicator, as mentioned previously. The market had already begun to decline in 1981, resulting in a 10% drop that year. The only reason the market rebounded so quickly was because of the aggressive action of the Federal Reserve.
The early 1990s is another example. This was a more mild inflationary period, but the Federal Reserve tightened the money supply. The stock market lost over 6% in 1990, but because the recession was tame, it was short lived.
Bottom Line on The Unemployment Rate
The unemployment rate is an important indicator of the economy’s health and significantly impacts the stock market. When you see the unemployment rate increase, you can expect that stock prices will fall since there will be lower demand for stocks, as well as goods and services.
If you are a stock market investor, keep a close eye on the fluctuations in employment rate and be prepared to act accordingly.
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