Unemployment, Recessions and Reflexivity

By Tim Pierotti

This morning’s employment data has equity markets rattled and the bond market rallying. Financial media is squarely focused on the Sahm Rule which states that when the three-month average of the unemployment rate moves up by more than 50 basis points, a recession is sure to follow. There is nothing particularly insightful about the rule. Anyone can look at the chart below and see that since the end of the second world war, anytime we have come out of a period of full employment, a recession has followed.?

We are well aware of the old saw that only a fool believes that “it’s different this time”, but we are certainly open to that idea. George Soros introduced the investing world to the concept of reflexivity: the idea that fundamentals drive asset prices, but that asset prices, in turn, then drive fundamentals. The economy and markets are a never-ending series of occurrences and reactions, and reactions to those reactions. Apologies if this sounds like a bit of a word salad, but the point I (and Mr. Soros) are making is that it is very hard to know the future because there are so many potentialities and reactions to those outcomes.

Let’s look at the most obvious example of reflexivity in the economy today. Markets are reflecting that employment is weakening as is the all-important housing market. Bonds all along the curve have rallied, due to the slowing data, and therefore mortgage rates are falling fast. So far, the decline in mortgage rates has failed to stimulate demand, but that does not mean that a further drop in rates won’t stimulate demand going forward. The key reason why we remain of the view that a recession may not be imminent is our view that, unlike 2008, there are more buyers than sellers in housing. That said, if a continued sell-off in equities weakens consumer and business confidence, all those prospective buyers may choose to rent for another year…reflexivity – the asset price tail wags the economic fundamentals dog.

I understand this is all a quintessential illustration of economic equivocation, but my point is not about hedging my bets as much as it is to reiterate the difficulty of forecasting. In other words, I don’t have a crystal ball, but neither do all the forecasters espousing certainty on CNBC.

Volatility is clearly rising and that means that investors who have enjoyed the incredible momentum of the last 18 months or so, should manage risk accordingly. While we remain sanguine on our economic outlook, we continue to see the risk/reward in equities as poor. Valuations are high. Expectations for earnings growth are also high at a time of slowing nominal GDP, which suggests that we are going to continue to see negative revisions on Wall Street to future earnings growth. No need to panic, but let’s be careful out there. Stops are always your friend.

Andrew Keizer Anthony Lewis Katie (Munn) Gaunt Charlie Yoachum Alex Samoila Drew Dokken Wade Dokken Lincoln Collins Matt Hamann Oliver Moon Jackson Bolstad Brooks Boucher M.J. Schiff, CLTC? Tim Pierotti Alex Strandell

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