So much for the disconnect between the market and the economy.
Ever since stocks bottomed on March 23, we’ve been wondering how the S&P 500 index —up 43% from then through Thursday’s close—could keep going higher. Now we know.
On Friday, we learned that the U.S. economy added 2.5 million jobs in May. It was predicted to see job losses of about 8 million. The unemployment rate unexpectedly fell to 13.3%, down from 14.7% in April and far better than the 20% predicted by economists.
To say the number was a surprise understates just how unexpected the good news was to everyone but the stock market, which has been telling us that good news was coming. “Clearly, the equity market sniffed out that the recovery is ahead of pace,” says Dave Donabedian, chief investment officer at CIBC Private Wealth Management.
It’s easy to forget that the stock market is a leading indicator—it starts to respond before we get the data. That’s why the S&P 500 was already in free fall when the World Health Organization declared a pandemic on March 11 and was starting to rise as the headlines kept getting worse. It’s also why the Dow Jones Industrial Average climbed 1727.87 points, or 6.8%, to 27,110.98 this past week, while the Nasdaq Composite rose 3.4%, to 9814.08, and the S&P 500 gained 4.9%, to 3193.93.
It isn’t that everything is perfect. As good as the numbers were, the jobless data contained puzzling quirks. For one, they probably overstated the improvement by not classifying employed workers who weren’t on the job as unemployed. The Bureau of Labor Statistics acknowledged that if it had, the unemployment rate would have been 16.3%, notes David Rosenberg of Rosenberg Research.
Rosenberg also points out that the Paycheck Protection Program encouraged small businesses to rehire workers in May so their loans would turn to grants. “Insofar as this shift has already happened, we may well see the hiring rate decline going forward,” he writes. “This is why it could be a big mistake to extrapolate today’s number because the impact of this statistical quirk was likely very significant.”
That risk could grow if a new stimulus bill—something that the market is betting on—isn’t passed. On the surface, passing such a bill would appear less likely following the payrolls number. White House economic advisor Stephen Moore, for instance, said that one isn’t needed now. Still, CIBC’s Donabedian doesn’t think that’s too much of a problem yet with an election just five months away.
“We’ll hear skepticism from the few remaining fiscal hawks in Washington,” he says. “But no one wants to have to defend being called a Scrooge.”
Similarly, the Federal Reserve, which meets this coming week, might feel pressure to dial back some of its monetary support for the market if the economy is recovering quickly. The payroll news pushed the 10-year Treasury yield up 0.085 percentage point to 0.903% on Friday after ending last week around 0.65%. If yields rise too quickly, investors could start worrying about the Fed’s dedication to its easy-money policy and stocks could take a hit.
What to do against that backdrop? This is the Trader column, so we trade. For now that means riding the cyclical wave. Wells Fargo Securities strategist Christopher Harvey, who told investors to buy value stocks in mid-April, recommends they continue to consider cyclical components of the market instead of secular growers. That means favoring credit-card companies, housing stocks, and the like, as well as hardware and semiconductors in tech instead of software.
“We want to fade anything with strong momentum,” Harvey says. “Find your laggards, your beaten-down broken stories, your contrarian stocks.”
The good news is that cyclical stocks might also be where the value is in a market that, on its surface, looks like one of the most expensive ever. Leuthold Group strategist Jim Paulsen broke the market down into two groups, one containing the top quarter of stocks by valuation and the other the remaining 75%, and compared them going back to 1950.
While the most-expensive stocks have gotten far more expensive—the average valuation has risen from 26.3 times to 38.3 times—the average for the remainder of the market hasn’t changed much. It’s 14.5 times versus 13.2 times. The takeaway: “The broad market is not overvalued,” Paulsen says.
Will things go smoothly? Certainly not. There will be hiccups along the way, and there’s still a lot that needs to happen before “mission accomplished” can be touted. Markets don’t go up forever.
But they are always right.
Write to Ben Levisohn at Ben.Levisohn@barrons.com