Chart of the Week - Stock/Bond Unemployment
Chart of the Week - Stock/Bond Unemployment
Don't fight the cycle when it comes to picking stocks vs bonds...
Chart of the Week - Stock/Bond Ratio vs Unemployment Rate
Here’s an interesting chart ahead of this week’s employment numbers. It shows the US stock/bond ratio (S&P 500 vs Treasuries — both in Total Return terms, and detrended*) vs the US unemployment rate (displayed inverted).
There is a clear and logical link between them: when the unemployment rate is low the economy is doing good, capacity is tight, typically you have high nominal growth, expanding earnings, and rising interest rates. That’s generally good for stocks and bad for bonds.
When the unemployment rate turns and heads higher, that usually means recession or slowdown, weaker earnings, excess capacity, lower inflation and lower interest rates. That’s typically bad for stocks and good for bonds.
So one takeaway is that if you want to get your active asset allocation weights between stocks vs bonds right, then watch the unemployment rate closely (or at least have a very well-informed view of where it’s heading!).
Another takeaway is markets are currently pricing-in good times ahead. Typically markets will attempt to sniff things out ahead of time, so the optimistic take is that the market is right and the economy is going to stay in expansion, and the labor market will remain tight.
Naturally this also means that things could unwind pretty quickly if the unemployment rate does turn the corner — especially given the lopsided valuations within equities, and relative to bonds. This is a time to focus on process and make sure you have the right framework and indicator set to navigate the next steps.
Key point: Know the unemployment rate, know the stock/bond ratio.
*p.s. the reason for detrending the stock/bond ratio is that over the long-run, stocks beat bonds (albeit with sometimes WILD gyrating exceptions to that rule — know the cycle, love the cycle) …so therefore the relative performance line is going to be trending over time. But because the unemployment rate is basically constrained within a range (mean-reverting/stationary), we need to put the stock/bond ratio into a similar type of regime, and that’s what I aim to achieve by detrending it (which in practice is simply deflating it by the expected level from a simple regression). That keeps the signal, but discards the trend, and leaves us with more of an apples vs apples outcome.
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Aside from the chart above, we looked at several other charts and issues:
Crude Oil Price Outlook: interesting technical setup (+catalysts)
Stocks vs Bonds: reconciling the short-term vs longer-term outlook
Frontier Markets: frontier market equities are looking interesting
GSV vs ULG: unique perspective on an interesting subset of global equities
(re)Thinking Valuations: (preview of an upcoming educational piece)
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Callum Thomas
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