Trading, What’s the Correlation between the Stock Market and Unemployment

9 February 2023 - 15:54

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Is there a correlation between the stock market and the trend in the unemployment rate?

Trading, What's the Correlation between the Stock Market and Unemployment

In recent times, especially in the last year, the work of central banks with regard to interest rates and inflation has returned as a market mover. This market mover was not seen since the subprime mortgage crisis, a period in which central banks had a real blow in terms of operations, going from raising rates to lowering them in the space of a few months.

These movements in the liquidity available to the financial system have led to strong market movements that have characterized the real economy, especially a market that we could define as fundamental for the economy and which constitutes a real bridge between the financial market and monetary policies , we are talking about the labor market.

The main indicator of the labor market trend is the unemployment rate which, especially in recent periods, is once again acquiring a certain importance, above all as an indicator of the solidity of the economy and above all as an anticipator of a downward trend in inflation. But can the unemployment rate be used as an "Indicator" for the financial markets? In a sense we could say yes, let’s see in this article.

Unemployment rate and financial markets after 2009

Immediately after interest rates and inflation, the unemployment rate is the most important quantity at a macroeconomic level and much debated as an object of study by big names in the macroeconomic panorama, above all Modigliani who, together with Papademos, theorized the Nairu, the “non accelerating inflation rate of unemployment”, i.e. he theorized an unemployment rate which keeps the level of inflation constant and in fact an unemployment rate which does not directly affect the trend of inflation.

This was just one example of how the unemployment rate is a fundamental component within macroeconomic studies and with regard to the Nairu we can say that at the moment we have very little empirical evidence in this regard. On the other hand, however, returning to the normal macro theories which predict that as interest rates increase we have a decrease in inflation and an increase in the unemployment rate, we see precisely this situation in the economy at the moment.

Rising rates, declining inflation and a labor market that by its nature is "lagging" (which moves behind the other indicators) still remains at its lowest. When the unemployment rate is at its lowest, what does the market do? Let’s take for example the situation present in mid-2009, when the equity markets had resumed their upward run, especially the Nasdaq, after the collapse of Lehman Brothers and the sharp reduction in liquidity following the most famous crash in recent financial history.

When the stock market began its recovery, the unemployment rate was at a high, precisely close to 9.5%, a rate very far from the current US unemployment which stands at 3.4%. From there, we have seen equity markets recover strongly along with a steady decline in the unemployment rate.

What happened before? Exactly the opposite, i.e. when the stock market started its descent, the unemployment rate was just above the lows, it had practically just started its rise after a long period of stagnation at close to its all-time low. In practice there is a negative correlation between the unemployment rate trend and the market trend as we can see inside the graph, with the Nasdaq weekly chart at the top and l at the bottom trend of the unemployment rate.

The situation also seems to coincide in terms of timing even if we remember that the unemployment rate is a lagging indicator, i.e. it lags behind what is happening but what interests us is its main trend and how it moves when it recovers from a historic low.

What’s happening now?

In this context we see a situation similar to that of the pre-Lehman crisis, with rates on the rise and inflation that is falling after reaching highs. In fact, it is precisely in this context that we see a stock market that is still holding up to the lows, with a strong rally that we saw starting at the end of 2022, in correspondence with an improvement in the labor market.

Attention precisely to this factor, namely the fact that the unemployment rate is at its lowest and, indeed, is still improving. This should be a wake-up call as from these levels it is difficult to see further improvement in the labor market, therefore the probability of seeing even further declines in the unemployment rate is very low.

The probability of seeing a worsening of the unemployment rate is much higher and therefore, given the inverse correlation between markets and unemployment seen since 2009, we could hypothesize that at this moment the market could be forming highs and when the unemployment rate will start to rise and confirm this trend, at which point we could see a sharp drop in the markets, perhaps going to create new lows compared to last year.

This correlation is interesting as we are also in a macroeconomic situation where central banks have the role of undisputed protagonists and each decision of the latter has a decisive impact on the future performance of the economy.

This correlation explains also the recent trend of the stock markets which have seen very strong increases in a short time and in correspondence with these increases we have seen an improvement in the labor market with an unemployment rate that beat the latest estimates of the operators who expected a deterioration, expectations denied by the data which instead marked a further surprising all-time low of 3.4%. Therefore, pay attention to the trend of the unemployment rate, above all to its future upward recovery since its recovery could mean a peak in share prices and a probable market collapse in the next months.

Original article published on Italy 2023-02-07 08:57:00. Original title: Trading, correlazione tra mercato azionario e disoccupazione

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