WASHINGTON — We’re currently in the longest streak of monthly jobs gains above 200,000 since 1994. While this is good news for those who have been unemployed and their families, it’s not necessarily good news for investors.
So why is a good jobs report bad for the stock market? It comes down to what we expect the Federal Reserve to do with that good news.
After the Great Recession of 2008, the Fed was deeply concerned about the economy’s ability to continue growing and creating the jobs that are its life blood. As such, they dropped short term interest rates to 0.25 percent (as part of the many extra ordinary measures they took) to stimulate growth, and have kept rates at this historically low level for the past five years.
Since that time, we’ve been in a yield drought with the yield of the 10-year Treasury averaging just 2.8 percent. Our options were either to accept those paltry returns or take additional stock market risk. For retirees and those on a fixed income, neither choice was good.
Each month that we have a good or better than expected jobs report, the Fed moves closer to an interest rate increase — something they have indicated they plan to do starting midyear. When the Fed begins increasing interest rates, it incrementally raised rates until a target inflation rate is reached, in this case, around 2 percent. So a move to increase interest rates is just the beginning. And it may signal the end of the stock market party.
As interest rates rise, investors have more choices of where to put their money. Why take stock market risk if you can get a 5 percent or 6 percent default-risk-free rate with Treasuries? We don’t believe that a quarter of a percent increase in interest rates will cause investors to abandon stocks, or that the 10-year Treasury will achieve those yields anytime soon. But the impact of the Fed increasing short term rates is a signal to the bond market of its growing confidence about economic stability, and will likely cause the 10-year Treasury interest rate to climb.
There’s an interesting correlation we discovered between the 10-year Treasury rate and the value of the stock market. When interest rates are higher, the value of the stock market as measured by the price-earnings ratio of the entire S & P 500 is lower. When interest rates are low, the stock market value is higher. This has been the case going back over 40 years with the exception of 2010 to 2013 during the time the Fed intervened to keep rates ultralow.
See our video, “Are Stocks Expensive” for a fascinating explanation of this phenomenon.
Assuming interest rates return to more normal levels, the best case is that the value of the stock market relative to the 10-year Treasury would also return to a more normal relationship — meaning the market could stay at its current level. A more likely case is those rising rates, along with the opportunity they represent to invest in less risky assets, would contribute to a falling stock market.
