Next stock market crash: Low unemployment signaling Wall Street pain

Reuters / Andrew Burton

• The unemployment picture on Main Street looks downright
  rosy right now, but that could be signaling future market
  instability and a possible stock-market meltdown.
• Jim Paulsen, the chief investment officer at Leuthold
  Group, notes that sharp stock-market sell-offs are usually met
  with widespread Wall Street layoffs.
• In an ironic twist of fate, signs of strength on Main
  Street could be foreshadowing a reckoning on Wall
  Street.

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When the housing bubble burst back in the
mid-2000s, plunging the US into a deep recession, many affected
workers on Main Street looked scornfully upon
their Wall Street counterparts.

While the normal folk lost their jobs and their houses, Wall
Streeters got off relatively easy. Sure, maybe some of them lost
their jobs as well — but the general feeling was that the big
banks set the middle class up to fail, then were let off the hook
with mass bailouts.

Well, the middle class may soon have its revenge, albeit in
indirect fashion, according to recent commentary from
Minneapolis-based Leuthold Group.

That’s because as Main Street workers enjoy their lowest unemployment rate in 18 years,
the fact that it’s so low could be portending a very dangerous
period ahead for markets, according to Leuthold’s chief
investment strategist, Jim Paulsen.

And when the market melts down, Wall Street trims the fat.

At first glance, it may seem counterintuitive that a strong Main
Street labor market is a signal of future market wreckage. But,
as Paulsen points out, it’s when positive conditions get
stretched too far that markets are most vulnerable to a shock —
largely because everyone is overly confident and complacent.

He also notes that low unemployment is generally characteristic
of upward pressure on resource costs, high business confidence,
higher inflation, rising yields, and restrictive policies. None
of those things are particularly conducive to prolonged market
strength.

“Low unemployment highlights an economic character which
simply has not historically been hospitable for financial
markets,” Paulsen wrote in a recent note. “Investors
should appreciate the ‘rare air’ they are currently breathing.”

If you still don’t believe Paulsen, consider the chart below,
which plots the S&P 500 alongside the US
unemployment rate. As you can see, periods when unemployment has
been below 4% (signified by the red dots) have usually preceded
stock market declines throughout history.

Leuthold
Group

You’ll note that the last time unemployment slid below 4% was in
2000 — the height of the tech bubble, and perhaps the most
glaring example of both investor and consumer overexuberance in
US history.

This dynamic also played out to a degree around the financial
crisis of 2008. While unemployment didn’t break the 4% threshold,
it came mighty close, and we all know what happened next.

“During the post-war era, the stock market has never done well
when the unemployment rate is at or below 4%,” Paulsen said.
“Yes, ‘never’ is a strong word, and while some of the red dots in
this chart do go up, they have never risen in a persistently
successful fashion.”

And as the mid-2000s financial crisis showed, the health of
markets has a direct effect on Wall Street employment. By the end
of 2008, in the meltdown’s immediate aftermath, banks had
cut more than 200,000 jobs.

Wall Street has always been more directly intertwined with
financial markets than Main Street. That’s because deals — and
fees — immediately grind to a halt when everyone gets nervous.
Financing becomes nearly impossible to obtain, and capital
markets grind to a standstill.

Not to mention the huge hits traders usually take during times of
turmoil. In addition to the outright losses associated with big
declines, the type of overconfidence that usually precipitates a
major market event usually keeps traders from adequately hedging.

It’s during times like these that Wall Street firms look to
streamline operations by cutting costs — which inevitably means
laying off employees.

“While admiring how great the underlying stock market
fundamentals are today, Wall Street employees may also want to
locate the closest government unemployment office,” Paulsen said.