Economists always look to the job market as an indication of economic health. While this is important from an overall economic perspective, jobs are a double-edged sword when it comes to stock prices. We all know that most of the US GDP comes from consumption, and a population that isn't working, or isn't working as much, has trouble keeping up their levels of consumption. If overall consumption drops, aggregate revenues and profits will drop, and stock prices will fall. Now that we've gotten that out of the way, let's look at it from the perspective of a single company.
There are many situations in life where what's good for an individual or company is not good for the broader society. Take factory pollution as an example. A company that produces toxic waste or pollution as a byproduct of production has its value system upset by converging forces. To increase earnings the company wants to produce more, but by producing more, they place an added weight on society through the extra pollution and waste created.
This same dynamic applies to the hiring practices of individual companies. Companies desire higher aggregate employment levels, because it means they can sell more products. But when it comes to their own hiring practices, they want as few employees as possible. Why? Because employees are expensive and eat away profits. So again we have conundrum. All companies want other companies to hire, but want to run their own companies as lean as possible.
[Read: The Truth About the Jobs Report and the Economy]
Wall Street rewards companies that run lean. If you don't believe me, watch for the next time a large company does layoffs and see what happens to its stock price. Unless the layoffs are a result of extremely poor operating conditions or events, you're likely to see the stock pop on the layoff news. This is because investors are instantly recognizing that a major cost cutting initiative has just been undertaken, and this has a good chance of boosting the bottom line.
It's common to think that more jobs means a better economy, which implies higher stock prices. While logical, this relationship often works in reverse. Stock prices are primarily a function of future earnings and free cash flow. The more a company can use technology or outsourced labor for its operations, the lower it can keep costs and the higher its profits will be. So don't be so shocked to see the market near all-time highs while some measures of employment remain subdued.
Stock picking and sector rotation are starting to matter more in the equity markets. This is because the correlation between various sectors and the broader market is decreasing. Since the financial crisis, the average correlation of the 10 S&P 500 sectors to the S&P 500 index has been high, reaching 95% in 2011. This means that on average, any sector of the market moved 95% in line with the broader market. In effect, it was the tide moving all ships; the ships varied little with one another and all we needed to do was to predict the tides (the macroeconomic moves) and we'd score consistent wins.
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At the end of the first quarter, 2014, the correlation between sectors and the broader market had fallen to 85%. In April it was 79%, and in May the correlation fell to 70.6%. This means positioning is becoming increasingly more important. Lower correlations are often viewed as a sign of improved capital market dynamics, as it implies a market held less hostage to macroeconomic events.
Depending on your investment style this may be a headwind or a tailwind. Money managers enjoy environments with lower correlations because it provides more opportunity to outperform the broader market, which they are typically benchmarked against. But this also means that investors must work harder for their returns. They must figure out where to be in the market, not just whether to be "in or out."
This chart below shows sector performance since the beginning of June. Growth oriented sectors are outperforming their more defensive counterparts. I think the resurgence we're seeing in growth will continue to play out for a while longer, based on improving fundamentals and continued easy money policies.
The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
