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• The October Jobs Report showed a -25% drop below the one-year average, but several temporary factors played a role.
• Our Unemployment Rate Indicator has provided surprisingly accurate signals to mark the beginning and end of recessions since 1948 with 100% accuracy.
• This article examines the signal currently presented by the URI, and discusses market conditions likely from this signal and what to expect ahead.
In this article, we look at the status of our $MT01 - US Unemployment Rate Indicator – which, historically, is a highly accurate indicator for the start and finish of economic recessions – with profound implications for investors today. We'll also examine the Rate of Growth for U.S. Gross Domestic Product (GDP), we clarify the intricate relationship between GDP Growth and Employment – and discuss the implications for the S&P 500 both six months and one year from now.
Pleasant Surprise from Jobs Report for October
Chart 1 below: Last Friday (November 1), the US Labor Department released its October
Nonfarm Payroll Report, which documented that the US added 128,000 jobs for the month. However, that figure is about -25% below the 12-month average of 167,000 (but well above the 56k and 62k lows posted in February and May).
Chart 1: 128,000 jobs were added in October – down -23% from the one-year average but higher than the 89,000 jobs expected by economists.
Last Friday's Unemployment Report also provided a surprise to investors because it was 44% more than the 89,000 jobs forecast by a consensus of economists. This relatively low expectation was primarily attributable to a manufacturing-workers strike at GM plants in Michigan and Kentucky that lingered for 40 days last quarter, affecting about 42,000 workers. About 20,000 temporary census workers were also sent to the unemployment lines, but these situations are always occurring and changing.
Not unexpectedly, Pres. Trump tweeted about the jobs report being "a bonanza" and inexplicably claims that there were 330,000 jobs added in October (rather than the actual number of 128,000).
Unemployment Rate Ticks Slightly Higher
Chart 2 below shows the Unemployment Rate (UER) ticking up to 3.6% from 3.5% – the result of an additional 325,000 Americans entering the job market to look for work, and thereby increasing the total workforce.
Chart 2: The Unemployment Rate ticked up, not from a decline in hiring but an additional 325,000 entering the labor force.
A 71-Year Record of Accurate Recession Signals
The Unemployment Rate (UER), tracked by the US Department of Labor and released monthly, has a 71-year track record (1948 - 2019) of providing accurate signals for the start and end of recessions. Moreover, by using a combination of a faster-moving average and a slower-moving average of the UER, we can generate even more accurate signals to help determine the appropriate level of market exposure to maximize profits at all times.
We employ the UER Indicator as a component in a composite of indicators to determine the proper market exposure for our ETF-based investment strategies. (We'll discuss the other components in future articles.)
Correction Characteristics
When the economy is in the constructive-growth phase of the business cycle, the stock market is generally in an uptrend. There will be times during these long, bullish growth phases when investor's emotions – their animal spirits – can get carried away with a kind of mass hysteria of the market, often causing them to overbid the price of stocks. Former Fed Chairman Alan Greenspan famously gave one of these times during the dot-com bubble the moniker of "irrational exuberance" – a pattern of overtrading that invariably ends in a sharp correction as stock prices rapidly revert to their mean.
However, as long as the underlying, long-term upturn remains intact – which it will if fundamental and macroeconomic indicators remain solid – these temporary -10% to -15% declines are considered to be corrections, and most investors should ignore them and ride them out. Historically, corrections occur about three times per year, on average.
Bear Market Characteristics
Significant problems can come from the times when recessions are beginning, but at the start, most investors don't have an effective method to distinguish between recessions and corrections. Many investors want to write out the corrections as we recommended above, but in the violence of selloffs at the start of recessions, 20 or 30% can be lost in a matter of a few volatile days.
Recessions are the most harmful threats that you must deal with as an investor and usually cause the stock market to enter a 'bear market,' which is a term of convenience, commonly defined as a decline from the prior high of -20% or more.
However, the average recession-related decline results in far worse damage and losses usually range between -30% to -60%. The Great Depression provided a nightmare exception and was accompanied by one of the worst market crashes in history, causing shares to lose about -85% of their value from 1929 to 1932, which then required the subsequent 22 years (until 1954) and a 667% gain to recover. Secular economic contractions are the market dynamic of which investors should be most wary, but at the beginning, they can be almost impossible to distinguish from corrections, which is why we focus intense effort on avoiding them.
Sophisticated quantitative investment strategies, such as the ETFOptimize Premium Strategies, can tell you precisely when market risk has increased to a level that justifies a move to defensive positions, and many ETF investments, such as fixed-income ETFs, defensive-stock ETFs, inverse ETFs, or precious metal ETFs, can be excellent vehicles that produce profits during economic contractions. Each of our models takes a different approach to defensive positions.
Chart 3 below shows that upturns in the Unemployment Rate (UER) from a bottom, upon crossing over an exponential moving average signal line (red line), provides a high-probability signal (red arrow) for the start of a recession, designated on the chart by gray bands.
Chart
3: This chart represents the hiring and firing record of tens of millions of businesses at 800+ points in time. Strangely, the companies seem to move synchronously in their employment decisions, which provides investors with an excellent signal for timing the market. Chart courtesy of StockCharts.com.
Also, notice that when the Unemployment Rate (UER – black line) peaks and begins to decline, it is a consistently accurate signal for the end of the recession and the beginning of a recovery. In this case, the red signal line is not used to identify the conclusion of recessions – instead, we derive the signal from a distinct reversal of the UER uptrend.
This reversal of ever-climbing jobless claims occurs near the end of recessions when US employers, collectively, gain enough confidence about the prospects for an economic turnaround, and they suddenly and almost simultaneously begin hiring workers again.
Note from Chart 3 above that Unemployment Rate inflection points – both at the beginning and at the end of recessions – are either sharply pointed valleys that occur when a declining unemployment rate abruptly turns higher (recession start) – or sharp peaks that suddenly develop when an increasing Unemployment Rate stops, pivots and begins rapidly declining (recession end). When the layoff or hiring decision comes each cycle, it's not wishy-washy with whipsaw signals – the trend change happens definitively with sharp changes of direction.
The US has an estimated 32.5 million businesses of every size and variety – or about one business for every ten citizens, and Chart 3 above shows a statistically representative sample of the cumulative hiring and firing decisions of those businesses every month for the past 71 years. What is incredibly fascinating is that the chart demonstrates abrupt, nearly simultaneous collective choices from millions of individual business owners and managers.
These business-cycle-focused hiring decisions come from a broad spectrum of people with very different business needs, including (for example) an HR Director overseeing a workforce of nearly 5,000 tech support professionals in Cupertino, CA; the CEO of a midsized company that employs 250 engineers in Austin, TX; or the owner of a small, five-person Jewish restaurant in Cherry Hills, New Jersey – and they all seem to be amazingly synchronous in their decision to end layoffs, reverse course, and begin hiring (or the reverse) – almost simultaneously.
It doesn't seem possible that all those millions of businesses move as one, like a school of hundreds of fish simultaneously swerving to and fro without a detectable signal between them, yet the similarities are profound.
The Most Crucial Question Facing Investors Today
Looking at the steadily declining black line on the far, bottom-right of Chart 3 above – investors want to know when it will stop, reverse course, and begin heading higher – which will signal the beginning of the next recession. Our firm does not attempt to read the tea leaves and predict when this – or any other aspect of the market will happen, and I won't try to do that in this article, either.
Instead, we have a far better approach: we use sophisticated quantitative systems that each week automatically assesses a composite of high-probability signals from a selection of 38 critical data sets – from the realms of macroeconomics, fundamentals, sentiment, and technical indicators – to assess current conditions using coincident and leading indicators to ensure that our investment decisions are accurate and profitable.
If we look to history for a hint of the timing of the inevitable coming recession and how much lower the Unemployment Rate might drop before it occurs, Chart 3 above shows that there have been only three times in 71 years that the UER has been lower than it is today; 1948 – 3.4%, 1953 – 2.6%, and 1968 – 3.4%.
The bottom line is that there has only been one time in history when the Unemployment Rate dropped to a significantly lower level than today – to 2.6% in June 1953. While statistically, it is unlikely that we'll see the UER decline to that incredibly low level again, it is possible.
Moreover, some might say it is even more likely we will revisit the 2.6% level because of the depth of the last recession, in which the Unemployment Rate reached its second-highest level in modern history at -10%. Additionally, recoveries from past Financial Crises have been long, but frail and tepid, with the current business cycle and bull market ranking as the longest in history at 10+ years.
This weak economic growth is the result of banks and other financial institutions being severely damaged during the crisis, which substantially handicapped their ability to lend – the primary fuel for the world's economic growth. This recovery may not just be the longest, but might also be the weakest we'll ever see in our lifetimes.
As shown in Chart 5 below, this recovery has undoubtedly been weak, and despite the current administration's claims otherwise, GDP growth is no different than it was under the previous administration, averaging the same very anemic 2.01% since the recovery got up to full speed in 2010.
Notice the growth surge to 3% in 2018 – due to the December 2017 tax cut, but that spurt began petering out a year ago, and growth has returned to a 2% annual rate. Since gaining the 2% level, the rate of growth has primarily stayed between 1% and 3%, nothing like the wild swings you'll see in the next chart.
Chart 5: US GDP growth has averaged an anemic 2.01% since the recovery got up to full speed in 2010.
The truth is that US GDP has been steadily declining with each passing decade since the post-war period began – when America became the world's economic superpower. As the US economy continues to mature, it is following the path of many older civilizations that passed before us. This statement doesn't mean that Americans won't have a prosperous future, but the economy won't be as robust (nor as volatile) as it has been in the past.
Notice in Chart 6 below that GDP (red line) has steadily declined from an average of about 5% from the 1950s-1970s to only 2% today. However, accompanying that subdued growth is the benefit of less volatile swings of GDP highs and lows. Nor are we seeing an overheated economy that's building bubbles, such as (most recently) the dot-com bubble (the late-1990s) or the real-estate bubble (mid-2000s), which, when burst, triggered the last two recessions.
Moreover, we're not seeing the wild economic swings during prior eras that seemed to bounce directly from one extreme to another every few years. The economy would grow at a comparatively stunning, fever-pitched pace, followed by a sharp drop into the abyss of economic contraction and deep recession.
Click to enlarge
Chart 6: US GDP growth has steadily declined as the economy matures, but the wild swings have also largely disappeared. Click to enlarge.
While you may wish that the US economy was growing at a faster pace, you may not like the mind-numbing volatility that can accompany that pace. The US economy may have evolved from the hare to the tortoise, but slow and steady might have a better chance to win the race in the long run.
Unemployment Rate Signal Remains Bullish
Recessions present the most significant risk factor for buy-and-hold investors. For example, buy-and-hold investors incurred losses of -55.06% in 2008-2009 and -47.42% in 2000-2003. Losses such as these take many months and often even years to recover – with a -50% loss requiring a 100% profit to return to breakeven. Buy-and-hold investors required 5.5 years from start to finish to recover the -55.06% loss for the S&P 500 ETF (SPY) in 2008-2009. By employing our robust quantitative signaling system, ETFOptimize subscribers sidestepped all of that loss and continued profiting from modern, defensive ETFs throughout the Financial Crisis.
Released by the Department of Labor each month, increases in the Unemployment Rate have historically provided a near-coincident indicator for recessions and investment environment – attributable to its historical ability to identify the beginning of recessions in real-time. However, investors should never use the Unemployment Rate as a stand-alone indicator. Instead, we use it as one component in a robust composite of macroeconomic, fundamental, and technical indicators. When combined, a composite of this type can provide accurate, weight-of-the-evidence signals that identify the beginning of market expansions and contractions.
Chart 7 below displays the Civilian Unemployment Rate in the bottom window (blue) for the last 20 years through the October Nonfarm Employment Report (released November 1, 2019). The US Unemployment Rate rose to 3.6 percent in October 2019 from 3.5 percent in September. It is still the lowest jobless rate since December 1969 (50 years).
Chart 7 also shows our MT01 - Unemployment Signal (red) in the middle window, which identifies periods of increased risk when it drops to zero. Notice that this indicator threatened to signal increased risk during the fourth quarter 2018 correction – before moving back up above 6,000 – to normal conditions and a signal of reduced risk. However, investors should keep in mind that $MT01 is but one component in a 38-component composite signal system. By using a weight-of-the-evidence approach to decisions about timing and ETF selection, you are able to dramatically improve the number of successful trades, consistently profitable years (100%), minimal drawdowns, and exceptionally high Risk-Adjusted Returns.
Chart 7: S&P 500 ETF (SPY) in the top window, Civilian Unemployment Rate in the bottom window, and our Unemployment Indicator (red) is shown in the middle window.
The reason the Unemployment Rate provides an excellent recession indicator is that businesses are very sensitive thermostats of the US economic environment. When internal sales forecasts begin to decline, the marketing department is meeting increased resistance, and enthusiasm for a company's products begins to wane, experienced business managers know to scale back on hiring new employees. If these trends continue, managers follow with outright cuts in staffing, traditionally a company's most substantial cost of doing business, and the unemployment rate begins to rise.
"...with the Unemployment Rate at a 50-year low, there is probably only one direction it can go."
This dynamic shows up immediately in Initial Unemployment Claims and soon after that in the monthly Civilian Unemployment Rate, making it an excellent harbinger of economic contraction and the related selloff of equities. The current status of our Unemployment Signal remains bullish at this time, but with the Unemployment Rate at a 50-year low, there is probably only one direction it can go.
While the Unemployment Rate may linger at this low level a bit, we pointed out in Chart 3 above that the turn point is usually somewhat abrupt and definitive. Most investors realize that we are much, much closer to the end of this expansion than we are to the beginning.
We are seeing a classic pattern that marks the long, drawn-out final stages of a bull market, with steadily eroding economic indicators that will one-by-one turn negative. We could have as much as another year to go in this expansion – but more likely, it's much less.
Quantitative strategies identify when a critical mass of these indicators has reached a tipping point, signaling that it is time to move towards defensive positions.Stick with your strategy's recommendations, because they are designed to identify and profit from these changes in our current market environment, assessed every weekend.
If you have any questions or comments about this issue of ETFOptimize Insights, please contact us with a Support Ticket.
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