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When the unemployment rate is very low, it is often due to the economy doing very well. In fact, very low unemployment often translates to already high stock prices and for investors buying at that particular stage in the cycle is often detrimental to their portfolio returns.
What we know about the stock market is prices are dependent on the business fundamentals, meaning what the business has done since its inception in addition to the future opportunities and future profits. As North American investors have studied the stock market since 1790 when the Philadelphia Stock Exchange was created, we’ve seen it all before. The economy often moves in cycles, with a recession and a slowdown in spending occurring usually every 5 to 7 years. Although there is no specific time table, the indicators are there to be missed by investors.
As an example, high inventory levels are one of the major leading indicators of a recession. Let’s assume in the following example, we own a company which manufactures and sells the “Johnny-On-the-Spot” temporary mobile bathrooms which can be used at construction sites and sporting events. Although this is not the most romantic example, it is the cleanest example.
Assuming we are 5 years out of our previous recession and things are going very well in our manufacturing company. The crappers are flying off the shelves. We have finally resumed production at our previous peak before the recession which occurred 5 years ago. Today, we need to expand the manufacturing plant and hire more workers. This is a wonderful problem to have.
We are expanding both human capital (labor) in addition to physical capital (machines) in the hopes of obtaining a positive return, contributing more to our financial capital (money or retained earnings). As we have seen a steady rise in demand for our toilets in the past 5 years, it is completely reasonable to increase our production capacity to meet the higher demand. We make the decision to hire more people while expanding our manufacturing facility. We are expanding the business.
Fast forward one to two years into the future and we are now working in a state of the art manufacturing facility with much greater capacity than was required one to two years prior. We continue producing at a lower cost and take business from our competitors. Things are going very well until we produce so many toilets, we have a warehouse full of inventory and we are not able to sell them fast enough. We are in the crapper. We lay off workers and temporary reduce our working hours from 8 to 7 hours a day or potentially close smaller manufacturing facilities. It depends on the company. Some would move to 4 day work weeks.
Although things are going fairly well in the economy, we have simply overproduced for a demand which we overestimated (or so we think). Looking at other manufacturing companies, we notice a number of them in other sectors of the economy who are in the same situation: closing plants, laying off workers, cutting prices to move inventory. Things are beginning to slow down as we are at the tip of the economic slowdown. Just weeks ago, everyone was working and good labor was hard to come by. In addition, overtime was plentiful and in turn, some employees chose to hunker down and work extra hours and buy a motorcycle or a boat – toys for fun. Just one year of extra overtime and the new toy could be paid off.
Moving forward to quarterly earnings, company management reports the building of inventory and the failure to increase profits as was expected by shareholders. The boom times are clearly coming to an end. The result of finally achieving full capacity from a high production level is the unemployment level is very low. Everyone is needed to aid in the production of goods and services in the economy. In fact, it is arguably when we reach record low unemployment investors should sell their stocks and stash more money under the mattress. Low unemployment often coincides with the peak in corporate earnings.
From the workers perspective, it is very difficult to obtain good employment in good times as everyone is looking for a better job. In bad times, it’s near impossible. Everyone is looking for either a better job or just a job. In many cases, they are looking for a second or third job to pay the bills. Taking Alberta, Canada as an example, there was a large number of skilled and semi-skilled laborers making an excess of $100,000 annually. In some cases, unskilled laborers could be making close to six-figure salaries. It was completely unheard of.
Taking Alberta as an “Under a dome” type of situation, there were only so many workers willing to work in remote or semi-remote places like Fort McMurray and make the big bucks while oil was well in excess of $100 per barrel. At a price of $30 to $50 per barrel, a large number of these workers have been put out of work and are leaving the dome to find another job under a different dome. Effectively, there are so few jobs for so many out of work and underemployed people, the consumption of this segment will decline and production will have to be cut to catch up.
Looking at low unemployment and how it is good for investors is actually a myth. Stock prices are forward-looking whereas the employment data is backwards looking. A potentially leading economic indicator to monitor is record low unemployment. It has already told the stock market, the only question: will investors listen.
Ryan Goldsman is a Toronto based Certified Financial Planner.