Submitted by Lance Roberts via STA Wealth Management,

This past Friday, the Bureau of Labor Statistics released the unemployment data for October which surpassed even the most bullish Wall Street forecasts. The news that the economy added 271,000 jobs for the month (vs expectations of 182,000) sent predictions of a Fed rate hike in December soaring as the unemployment rate fell to 5%.

As Akin Oyedele via Business Insider wrote:

"After months of guessing, Friday's October jobs report jolted the market's confidence that the Federal Reserve could — and perhaps would — raise rates next month. This looked like the kind of data that the "data-dependent" Fed needed to argue that the labor market had shown 'further improvement.'"

Akin is correct and the market agreed as the probability of a Fed rate hike this year soared above 70%.

The support provided by the increase in employment, the drop in the unemployment, falling jobless claims and rising asset prices all suggest that the economy is, at long last, on the verge of acceleration. Right?

Maybe not?

Records Are Records For A Reason

Think about the following statement for a moment.

"Jobless claims recently reached the lowest level in 42 years."

That is certainly a very "bullish" economic data point. However, when not put into some form of "context" it is really fairly meaningless. The chart below provides the "context."

Notice that each of the "lowest levels of jobless claims since..." was set just prior to the onset of the next recession.

Since the economy is driven by "full cycle" patterns of growth, to peak, to trough, any data point that reaches a "record" level should be viewed within the context of the economic cycle. As with jobless claims, a recovery from a record high in jobless claims to record lows suggest a completion of the economy recovery from trough to peak. Importantly, the economy can not remain indefinitely at a peak, the other half of the normal economic cycle will ensue at some point.

This is the point made by James Paulsen of Wells Capital Management in a recent analysis of what "5% unemployment rates" tell us about future stock and bond market outcomes. To wit:

"Historically, the stock and bond markets have done much better when the labor unemployment rate is above 5% (i.e., above full employment). Indeed, since 1948, annualized stock returns have been nearly twice as strong and long-term government bond returns have been almost four times greater compared to their respective returns when the unemployment rate is at or below 5%. Moreover, both stocks and bonds have tended to suffer more frequent monthly declines in fully employed economies. Finally, on average during the post-war era, once the unemployment rate reaches 5%, a recession has been less than two years away."

Paulsen provides a series of charts documenting when the unemployment rates were 5% or less as provided in the full PDF version below. However, I want to bring your attention to the points he makes about the relationship between unemployment rates and recessionary onsets.

"Moreover, Chart 3 illustrates the increased risk of recession once a 5% unemployment rate is reached. On average in the post-war era, a recession is less than two years away once a 5% unemployment rate is reached compared to about 4.2 years when the unemployment rate is above 5%."

Importantly, just because the unemployment rates is at 5% does mean that a stock market crash is at hand. However, it does suggest that the inherent returns received by stock market participants will likely be substantially different in the future as compared to those seen during the recovery from the post-financial crisis lows.

"Historically, as Chart 6 shows, the entire financial market risk-return frontier (which relates historic returns and risks associated with all stock-bond portfolios shown in 10% allocation increments) shifts significantly downward at full employment. The large black squares illustrate the annualized stock/bond frontier for all months since 1948 when the unemployment rate was above 5% while the smaller gray triangles illustrate the frontier only for those months when the unemployment rate was 5% or less. Several observations are noteworthy."

"First, returns from either an all stock or an all bond portfolio (or any combination thereof) is significantly less once the economy reaches full employment. Second, the lower returns offered by financial assets in a fully employed economy also have less volatility. Third, the portfolio diversification offered by combining stocks with bonds is far greater before the economy reaches full employment. Fourth, because portfolio diversification is not as effective once the economy reaches full employment, the return per unit of risk (i.e., the slope of the frontier or the additional total return per unit of risk achieved by increasing the allocation toward stocks) has historically risen much faster before the unemployment rate reaches 5%. Finally, the degree to which the mathematics surrounding the financial markets is altered by an economy reaching full employment is perhaps best highlighted by the following fact. The all bond portfolio in an economy with an unemployment rate above 5% has yielded investors about 8.6% total annualized returns with only 10.4% risk. By comparison, once full employment is reached in the economy, the all stock portfolio has only produced an 8.0% total return for investors with a much higher risk of about 13.9%!"

Mr. Paulsen's view support many of the points I have made recently about the lateness of the current market and economic cycle. To wit:

"It is becomingly increasingly clear from a variety of inputs that deflationary pressures are mounting in the economy. Recent declines in manufacturing and production reports, along with the collapse in commodity prices, all suggest that something is amiss in the production side of economy. While increasing interest rates may not 'initially' impact asset prices or the economy, it is a far different story to suggest that they won't. In fact, there have been absolutely ZERO times in history that the Federal Reserve has begun an interest-rate hiking campaign that has not eventually led to a negative outcome. The Federal Reserve clearly should not raise rates in the current environment, there is a possibility they will regardless of the outcome. The Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates would likely accelerate a potential recession and a significant market correction, from the Fed's perspective it might be the 'lesser of two evils. Being caught at the 'zero bound' at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline."

Of course, it is also worth mentioning that there is a significant difference between real "full employment" and "statistical" full employment.

Despite a strong headline in the most recent jobs report, the actual employment rate of individuals that should be working (excluding all those over the age of 55) has been falling in recent months. It is hard to suggest that the economy is running near full-employment with more than 54% of the working-age population sitting at home.

As Mr. Paulsen concludes:

"Historically, the statistical or mathematical properties of the financial markets have shifted as the economic recovery nears full employment (i.e., at about the 5% unemployment rate the contemporary recovery has reached). Traditionally, at this point in the recovery, the stock market suffers more frequent declines, bond yields rise more often, average annualized returns from both asset classes are lower, diversification benefits tend to diminish, and recession risk is enhanced."

I agree with Mr. Paulsen's point. With the actual economy, as witnessed by the plunge in imports, weaker than headlines suggest, the risk of recession has risen markedly.

Paulson - 5% Unemployment & A Shift in Market Mathematics