More Bad News on the Employment Front, So Why is Mr. Market Smiling?

Today the US Labor Department reported a job loss of 598,000 for January and an unemployment rate of 7.6%. These figures indicate the current stress on the economy and the distress many households are facing. Much will be said about these numbers, and economists and media people will no doubt crunch their numbers, extrapolate the trends and intone in morgue-serious tones about how these results are the worse since, 1981, 1974, 1933, etc.

Employment, like GDP, is a lagging economic indicator. That is, it is one of the pieces of economic data that shows improvement only after other signs of recovery have emerged. Leading indicators such as building permits, the average workweek, supplier deliveries, etc, are still negative but do not receive as much market or media attention as the monthly employment report.

Despite the unrelenting bad news on the employment front (we hear every day on CNN reports of companies laying off thousands of workers), the stock market is hanging in there. In the chart below we see that the market is well off its Q4 ’08 low and may actually be trying to establish a slight upward bias. In the face of worsening economic news, why is the stock market trading 13% above its lows?



We see three simple reasons for this.
1) Valuation. At some point, a stock will trade at a valuation sufficiently low to attract new money. Despite investor withdrawals over the last few months, mutual fund managers are still in the business of trying to outperform the market. Those following the “value” style of investing are no doubt attracted by the valuations the market is now offering on a large number of stocks. Many value metrics (price-to-book, dividend yield, etc.) are not necessarily tied to the current year’s earning expectations and may not need to decline much further despite a lingering recession.
2) The End of Technical Selling. During the worst days of October and November, it appeared as if the market was not working. The daily action in the market seemed totally unrelated to any fundamentals. The market would violently move up or down regardless of the news items or economic data points of the day. Much of this historic volatility was no doubt due to technical selling by mutual funds, responding to investor withdrawals and hedge funds reducing their leverage. Some time in December, we sensed an easing of this kind of market action. The market is still worried about the economy and volatility remains well above historical norms, but it seems to working “properly” again, that is, stock prices appear to respond to fundamentals as one would expect.
3) Discounting the Future. According to efficient market theories, the market is supposed to discount future events and not just the current situation. Because market prices should already fully discount all available information and investors should be putting capital to risk on the expectation of future developments, we should not be surprised to see the market today respond favorably to the employment report. Why? The market was already expecting bad news on the employment front. It’s not as if investors were waiting for the employment report to sell stocks. No doubt some were waiting for the report to buy stocks (because it was not materially worse than expected).
We have no way of knowing for sure whether we’ve seen the worst in the stock market or not, but we are encouraged by the fact that the market is well off its lows and it seems to be able to absorb waves of bad economic news without falling dramatically.