Are happy days really here again for the economy?
The stock market's impressive rally over the last six weeks has seduced unsuspecting investors into believing that they are. But based on the stock market's behavior on just two days during this period, I conclude that the economy most likely is in a recession.
Those two days were the first Fridays of April and May, on which the federal Bureau of Labor Statistics released the latest job-market data. On both occasions, the picture was far bleaker than expected. And on both occasions, the stock market fell significantly after the figures were announced, though after the May announcement, the market rallied later in the day.
It turns out that such negative reaction is a hallmark of recessions. It is relatively rare during periods of economic expansion, by contrast, when the stock market tends to react positively to weaker-than-expected employment data, historically on the grounds that it will reduce pressure on the Federal Reserve to raise interest rates.
I owe this insight to a recent study by three economists, John Boyd, finance department chairman at the University of Minnesota's Carlson School of Management; Jian Hu, an economist at the Federal National Mortgage Association; and Ravi Jagannathan, a finance professor at Northwestern University's Kellogg Graduate School of Management.
They studied the government's monthly unemployment announcements from 1962 to 1995, focusing on Wall Street reaction when the employment picture was reported to be either stronger or weaker than Wall Street was expecting.
With regard to weaker-than-expected data, the researchers found that the stock market's reaction depended crucially on whether the economy was in a recession (as identified by the National Bureau of Economic Research). During periods of expansion, the average daily reaction of the Standard & Poor's 500-stock list was to gain 14 basis points, or hundredths of a percentage point. During recession months, however, the S&P's average reaction was to lose six-hundredths of a point. This spread of 20 basis points is statistically significant, since the rest of the time the S&P 500's average daily gain is less than three basis points.
To be sure, these economists are not proposing that investors use their analysis as a market-timing tool to predict how the market will react to the monthly job figures. As they point out, the National Bureau of Economic Research does not know until months after the fact whether the economy is in recession. Even if this obstacle did not exist, you would still not be able to trade on the professors' theory, because doing so would require having advance knowledge of the government's announcement.
We can use the economists' theory, however, to ``forecast'' the current state of the economy. To do that, we only need to study how the stock market reacts to weaker-than-expected employment data. If it reacts negatively, as it did during April and May, the odds are good that we are in a recession.
You might wonder why the market reaction to rising unemployment is so different in recessions than in expansions. After all, regardless of the state of the economy, rising unemployment lets the Federal Reserve ease monetary policy. Why should that be bullish during expansions and bearish during recessions?
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