Why the S&P shrugs off the long-term unemployed
The below graph reflects the relationship between the U-1 portion of the workforce, or “Persons unemployed 15 weeks or longer, as a percent of the civilian labor force.” The three recent big rises in the S&P are not all the same—the post-2008 equity market rally has also been a big plus for the long-term unemployed, though despite record levels in the equity markets, the level of long-term unemployed remains very high—right around the early ’80s peak levels, when the U.S. was experiencing hyperinflation under the Reagan and Volker regime. The decline in the number of long-term unemployed is encouraging, though readers should note that, despite the 50% decline in U-3 Labor—the official unemployment rate—the similar 50% decline in the U-1 rate has still left the U-1 rate at extremely high levels. This article considers the trends in the U-1 unemployment rate and the implications for equity investors.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Why NAIRU (the non-accelerating inflation rate of unemployment) is important
The Bureau of Labor Statistics, or BLS, which gathers this data, also tends to use a 5.6% number for the non-accelerating inflation rate of unemployment. This is the theoretical magic number at which there exists enough slack supply in the labor market as to not create inflation—or a rise—in the level of wages. As we noted earlier, the official rate of unemployment, or U-3 rate, is currently at 6.7%. This is much better than the 10.0% we saw in 2009, and really not that far from the NAIRU target. As the graph above notes, the long-term unemployed are still quite numerous, suggesting that wage inflation is a long way away—three years or more? The above graph might suggest that the U-1 unemployed should be closer to 1.5% of the workforce rather than the current 3.3%. That means 1.8% of the workforce is quite available and not so picky with wages. Plenty of supply, so interviewees aren’t in a great position to negotiate wages like back in 2000.
For financial markets, this means you don’t have to sell your bonds in a panic just yet. For equity investors, you’d have to ask why it is that the stock market has risen so high while labor data is still quite weak. During both the Dot Com boom up to 2001 and the Bush Tax Cut and Housing Bubble boom up to 2007, strong equity markets seem to have contributed to pushing the U-1 labor to the bottom of its historical ranges. In the current recovery, this is far from the case. Equity investors would be wise to monitor labor market developments, as zero interest rates and large-scale equity buybacks aren’t necessarily the best fundamental reasons to buy and hold. Record corporate profits are definitely a great reason to buy and hold, but if the labor market doesn’t continue to improve, profit growth could be compromised. With the S&P 500 price-earnings multiple pushing 20 times versus long-run averages of closer to 15 times, you have to ask yourself if you’re really that optimistic about continued profit growth, or to what extent you’re the beneficiary of zero interest rates and equity buybacks.
To see a comparison of the long-term unemployed (U-1) data noted above with the short-term unemployed (U-2 data), please see the next article in this series.
For more detailed analysis of the U.S. labor market, please see Is Baby Boomer retirement more good news for stocks and labor markets? and US labor: Is the discouraged worker bad for stocks and bonds?
A credit comment: Caesar’s Entertainment—High leverage, marginal debt service coverage
Caesar’s Entertainment Corporation has a fairly small market capitalization of $3.57 billion, and a CCC credit rating (below Sprint’s BB credit rating)—the highest area of the below–investment-grade category. Reducing Caesar’s $21.54 billion of debt by the firm’s $1.71 billion cash position, we’re left with approximately $23.25 billion of net debt. In contrast to Verizon’s (VZ) 9.54% profit margin and Sprint’s (S) -8.5% profit margin, Caesar’s has a negative profit margin of -19.91%. Caesar’s revenues are $8.34 billion, with an EBITDA of $1.76 billion to service its net debt of $23.25 billion, while Sprint has $5.47 billion to service debt of $25.5 billion. Meanwhile, Verizon has $48.57 of EBITDA to service its net debt of $42 billion.
These differences in debt and EBITDA earnings drive the differences in credit quality ratings from the top of investment grade, Verizon (at BBB), to Sprint (at BB) and Caesar’s (at CCC). Caesars currently has a June 1, 2017, senior secured bond yielding around 11.00%, versus Sprint’s August 15, 2007, senior unsecured bond yielding 2.95%, Verizon’s February 15, 2008, senior unsecured bond yielding 2.00%, T-Mobile USA’s February 19, 2019, senior unsecured bond yielding 3.00%, and CIT Group’s February 19, 2019, senior unsecured bond yielding 3.46% (Bloomberg & Capital IQ, December 31, 2013 Quarter).
Equity outlook: Cautious
Should the debt ceiling debate re-emerge after the mid-term elections in November, and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Plus, even the global blue chip shares in the S&P 500 (SPY) or Dow Jones (DIA) could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the budget and federal debt issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment, or individual companies such as Wal-Mart Stores (WMT).
Without sustained improvement in economic growth data, there’s little doubt that the debt level issue and tax reform will be a big issue later in the year. Current economic data noted in this series suggests that the probability of the 2013 sequester issue returning—in one form or another—could be higher than many think. The data is simply not that robust—yet.
Equity outlook: Constructive
However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this series, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the S&P 500 (SPY) price-to-earnings ratio standing at 19.65 versus the historical average of around 15.50, the S&P is slightly rich in price—though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that is “on strike,” including corporate profits, into long-term fixed investments. This could lead to greater economic growth rates and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).