Can the US have a robust economic recovery without a fall in the unemployment rate? Probably not. GDP growth can be seen as the product of changes in two factors: the number of workers and productivity. Without an increase in the workforce, the country’s economic engine is operating on only half its cylinders.
Can the US stock market maintain a substantial advance without a decline in the unemployment rate? Certainly, it would be easier for US stocks to go up if the domestic economy is booming. But that may not be entirely necessary. Several reasons:
1. Only about half of the profits generated by publicly trade firms come from the domestic economy. The health of Europe (currently being invigorated by the collapse of the euro) and of emerging markets are also important.
2. Even the domestic portion of S&P profits doesn’t mirror the structure of the US economy closely. Some of the weakest economic sectors, like housing, commercial real estate or autos, have virtually no representation in the market. In addition, only the strongest firms are able to qualify for listing. So normally the performance of the domestic arms of publicly traded companies is far ahead of that of the overall economy.
3. (the real reason for this post) I think it may be important to distinguish between businesses that produce necessities and those that benefit from discretionary spending. Yes, this is a fuzzy distinction. Producers of pure commodities like energy may be one thing. But even staples producers have both value and premium brands, that consumers trade up and down between as economic circumstances dictate.
Still, there may be an important difference between the profit potential of companies that depend on having more people having jobs and those that benefit from already-employed people having more money to spend. I think the second group has much greater potential than the first. How so?
As their operating performance is improving, I’ve been noticing more and more companies who had reduced working hours, or wages/bonuses, or benefits like a 401k match, restoring them. The latest two examples have come this week:
a. Fedex, which also remarked in its May quarter earnings conference call on the “undue pessimism” of investors that’s not supported by the strengthening world economy, stated that it is reinstituting pay raises and is restoring half of its suspended 401k match. Personnel expense for this global company in the fiscal year just ended was something over $14 billion. My (admittedly rough) guess is that raises and 401k together will amount to an extra $100 million paid to US employees in the coming 12 months.
b. Wynn Resorts is restoring wages and working hours for most of its employees in Las Vegas to pre-recession levels, at a cost of about $7.7 million yearly. At the same time, in order to be able to do this (WYNN is cash flow positive but still unprofitable in Las Vegas) the company is laying off 261 workers.
This may represent the 2010 economic recovery dynamic in a nutshell: businesses not hiring anyone new, and maybe even laying some people off, but paying existing workers signficantly more than they are earning now.
The relevant investment question is what these better off workers will spend this extra money on. Of course, they’ll probably save a larger portion than they would have before the recession. But they’re certainly not going to spend it all on basics. There’s already evidence that some WalMart customers are trading up to Kohls, Target or Macy’s (although others are apparently trading down to the dollar stores). Maybe they’ll take a step further and trade up to mall stores. My guess is that people will splurge on smartphones, TVs and vacations.
In any event, however, the 90%+ of Americans who are working will likely be spending signficantly more in the year ahead than Wall Street now expects. So the portion of the S&P that depends on strong domestic consumer demand will probably do well.
If we add all this up, the 50% of the market that’s non-US has good prospects. Let’s say half of the remainder (probably too low) stands to benefit from spending by those now emplopyed. That would imply that at most a quarter of the market’s capitalization is going to exhibit earnings weakness. In my experience, the “good” proportion is high enough to be able to drag the “bad” part of the market along with it on an upward journey. Were the proportions reversed, the “good” stocks would be relative performers, but would likely be mired in a Japan-like swamp.
This story will take some time to play out. It may be another year, or longer, before consumer demand gains enough momentum for companies to begin to look toward the long-term unemployed as a source of workers. Chronic unemployment at a high level may not be politically acceptable (arguably it should not be acceptable). I have no idea when or how efforts might be made to redistribute economic energy from the 90% to the 10%–or what effects any attempts to do so might have on stocks. Something to be on the alert for, though.