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Taking stock, Part 4: Contrarian indicators

Jun 02, 2020 | Ben Graham, CFA


While the immediate future remains unclear, contrarian indicators can keep investors grounded in the belief the economic foundation will improve.

Taking stock is a five-part series placing trends in context for today's new world.

Periods of painful economic experiences are unsurprisingly some of the best times to allocate capital to equity markets, or at a minimum maintain exposure. This is usually because these periods of economic contraction require investors to behave in a manner divorced from a fear-focused market. Now that we’re several months past the COVID-19 bear market’s beginning, we believe the focus needs to remain on the future, not the painful recession-driven bear market investors recently suffered through. Contrarian indicators can be helpful to keep us grounded when our emotions try to tell us untruths.

Historical employment trends have been a very good contrarian indicator of future returns when registering an extreme reading. Put differently, when unemployment is at the ultra-low levels of approximately 3.5%, last seen in February of this year, S&P 500 future returns are well-below average. It then follows that when unemployment spikes, S&P 500 future returns are above average. This is typically because an unemployment spike is related to an equity market correction or bear market and a subsequent recovery is part of the natural ebb and flow following these periods.

Unemployment sits as 14.7% as of the end of April with consensus expectations for May showing a near-20% expectation, almost double the 1982 and 2009 highs of 10.8% and 10.0%, respectively. In fact, recent unemployment levels mark the highest on record, and they materialized in a matter of two or three months. Also, 2020 marked the fastest change in unemployment on record. Ouch.

U.S. unemployment rate
Chart: Unemployment rate

S&P 500 average 12-month forward return
Unemployment higher than average: 11.9%
Unemployment greater than 9%: 14.2%

Note: Shaded areas indicate U.S. recessions. May 2020 data is a consensus estimate, all others are actual results.

Equities painfully sold off while unemployment spiked in H1 2020, but as we look forward, unemployment is most likely to fall in future months and should act as a support to the equity market.

Source - RBC Wealth Management, FactSet; data through 5/31/20

Fortunately, there is a silver lining. When unemployment levels are higher than average, S&P 500 future returns are better than average. In fact, when unemployment is greater than 5.8% (average since 1948) the ensuing 12-month average return on the S&P 500 is 12.0%, 3.2 percentage points better than average. Taking it one step further, when unemployment is greater than 9%, which characterizes periods of intense economic stress, ensuing 12-month returns on the S&P 500 jump to 14.2%.

The second contrarian economic data point to observe is the Institute for Supply Management (ISM) Manufacturing Purchasing Managers’ Index (PMI), a survey of manufacturing sector purchasing trends at more than 300 firms. It measures industrial activity, and troughs in this measure are typically associated with recessions or other periods of economic strain where a recession nears, but doesn’t quite materialize. Readings greater than 50 on this measure indicate an expansion in the manufacturing sector while those under 50 indicate a contraction.

May’s 43.1 reading was preceded by April’s 41.5, and both are near previous recessionary troughs. Following the data again, future returns are consistently better when this reading is poor and improve when it’s elevated. In fact, future 12-month equity returns have averaged 17.9% in the 12 months following all readings below 45, similar to April and May, and are actually positive 85% of the time. This is nearly as favorable a backdrop as can be found over a 12-month time horizon given the uncertainty expected for the next few quarters.

ISM Manufacturing PMI
Chart: manufacturing activity

Note: Shaded areas indicate U.S. recessions. Readings above 50 indicate an economic expansion while those below 50 represent contraction.

Recessionary levels followed by an improvement in manufacturing activity are frequently associated with some of the best returns in the S&P 500.

Source - RBC Wealth Management, FactSet; data through 5/31/20

Using reliable and contrarian economic indicators can help investors stay grounded during periods of economic stress when their emotions and the tone of the day can prove distracting. Clearly, U.S. stocks took a painful bear market on the chin as unemployment spiked to nearly 20% and the manufacturing sector froze up. Furthermore, equities have sharply rallied by 36% from those lows on March 23.

However, one year from today, we think a recession should be in the rear view mirror and earnings should be growing quickly from the low bases being put in place now. And a few short months later, we believe investors will be squarely focused on their expectations for 2022. While the immediate future of equity markets remains unclear given the unknown shape of the recovery from the COVID-19 recession, contrarian indicators present a backdrop to keep investors grounded in the belief the economic foundation will ultimately improve as we move through these stressful times.