Unemployment Rate and Stock Market Returns (Backtest And Statistics)

What is the relationship between the unemployment rate and stock market returns?

This is a somewhat confusing and not-so-straightforward relationship. Thus, in this article, we try to investigate the unemployment rate and subsequent stock market returns.

Is the unemployment rate an essential determinant of stock market returns?

Yes, the unemployment rate is an essential indicator of the health of any economy. When the economy is good, profits tend to increase and vice versa.

When the unemployment rate is high, the economy (and society) is not producing enough jobs. Long periods of high unemployment bring down purchasing power and, thus, profits.

Opposite, when the economy thrives, companies hire more people, salaries might increase, and purchasing power might increase.

Unemployment and consumer spending

However, the relationship between unemployment and stock market returns is probably not as straightforward as we like to believe.

There are two reasons for that: the unemployment rate is a lagging indicator, and the stock market always looks into the future. A high unemployment rate today is yesterday’s news! That means a recession might already be discounted when it happens.

Stock market returns are determined by a myriad of factors, and it’s not easy to break down cause and effect. If it were, it would be easy to make money.

Unemployment and consumer spending

As a rule of thumb, high unemployment hurts consumer spending. Thus, companies make less money, and they might hire fewer people. Furthermore, they might look to automate tasks to save money, and productivity might increase.

Eventually, when we hit a cyclical bottom, profits rise because productivity has increased, and rising profits might make management hire more people (again).

As you might imagine, the economy goes in cycles.

Why is the stock market going up when unemployment is high?

This has happened in the past, and this doesn’t look right for many.

But the reason is simple: the financial markets look ahead. If they believe the economy will improve in the coming months, they drive up share prices, even though the current unemployment rate is increasing.

Unemployment rate and stock market correlation

We downloaded monthly unemployment data and compared it to S&P 500. We looked at the monthly unemployment rate and compared that to the closing price of S&P 500 that month. However, the unemployment rate is usually reported on the first Friday of the month, which is at least three weeks before the closing price of that month (in the stock market). Thus, there is a “lag” in our backtest.

Let’s make some backtest to find out what the correlation is like. The chart below looks at correlations between the unemployment rate and S&P 500 for six months, 12 months, 18 months, and 24 months: