The Stock Market's Labor Pains

The job numbers keep getting worse—and at a quickening pace. What does that mean for investors?

by Ben Steverman

Americans are losing their jobs at a steady clip. According to a Labor Dept. report released Sept. 5, the unemployment rate hit 6.1% in August, and U.S. payrolls dropped 84,000—with both numbers worse than economists were expecting.

After an initial decline, U.S. stocks seemed to shrug off the bad news by posting modest gains on Sept. 5. Nonetheless, there are plenty of reasons a weakening labor market should alarm investors.

For one thing, it's just more bad news for a stock market that already has had its fill. "It's the psychological effect of bad news," says Quincy Krosby, chief investment strategist for the Hartford.

The unemployment rate crossed the 6% threshold to reach its highest level since 2003. Many market experts said the level of unemployment wasn't as disturbing as the rapid pace at which it has moved higher: The rate was 4.8% as recently as February. The data "points to a re-acceleration in the rate of declines" in jobs, says Keith Hembre, chief economist at First American Funds.

Bad Sign For Profits?

That weakens the case for bullish investors, who hope the U.S. can avoid recession. "While I'm not conceding we're in recession, it appears we're getting closer to one," says Peter Cardillo, chief market economist at Avalon Partners.

Many optimists were hoping a resilient economy would deliver higher corporate profits in 2009. Recent data on the U.S. gross domestic product bolstered those expectations, with U.S. GDP registering a 3.3% increase in the second quarter.

"Investors have been teased by data over the last month or two that was suggesting we would skip a recession entirely," says Chris Johnson of Johnson Research Group. "There was some hope out there."

Now, those hopes have been, if not crushed, then seriously deflated.

Different Sort of Recession

In the stock market, the most obvious victim of higher unemployment is consumer stocks. More than 600,000 people have been dropped from payrolls so far this year, but it's not just the unemployed who cut back their spending at restaurants and retailers. Workers remaining on payrolls get nervous about their jobs, and economists expect them to get smaller raises.

John Merrill, chief investment officer at Tanglewood Capital Management, believes the U.S. is in "an unusual recession." Rather than a rapid deterioration, Merrill expects a "lengthy period of job losses."

"Problems in the economy are spreading to other areas," Merrill says. "It's creating a sluggishness [but] not a steep drop-off in [economic] activity." More and more groups of consumers are pulling back their spending—and more companies, such as Starbucks (SBUX), respond to slower spending by cutting back staff, he says.

Stress in Finance, Too

It's not just companies directly affected by consumer spending that feel the pinch. Unemployment also has an effect on problems in the financial sector.

"At the heart of the credit crunch is the housing market," says the Hartford's Krosby. A weak labor market raises worries about Americans' ability to pay their mortgages and other debts, and it makes them less likely to want to buy new houses, she says.

So why did U.S. stocks recover slightly on Sept. 5? The Dow Jones Industrial Average closed 32.73 points, or 0.29%, higher at 11,220.96, while the broader S&P 500 gained 5.48 points, or 0.44%, to 1,242.31.

Dave Rovelli, managing director of equity trading at Canaccord Adams says stocks bounced back a bit because they had already fallen so much in the days before the job announcement. On Sept. 4, major indexes fell almost 3% (BusinessWeek.com, 9/4/08).

Mirror of the Past

Also, employment figures are often seen as a lagging indicator for the economy and stock market. In other words, they document what has happened in the past. And in the past, Krosby notes, stocks have rallied on the expectation of good times ahead even as the jobless rate continued to rise and payrolls kept shrinking.

Unemployment, however, can be seen as a leading indicator of one trend, says First American Funds' Hembre: a drop in inflation. A weak labor market tends to cut off many of the trends pushing prices higher, he says.

A drop in inflation, in turn, allows the Federal Reserve to keep interest rates low. Hembre believes the Fed might even be able to cut rates eventually.

"If inflation stays in check and unemployment keeps going up, the Fed is not going to raise rates," Rovelli says.

Vulnerable Exports

That might be the only silver lining in recent job losses: Financial firms and U.S. homeowners need low interest rates to get out from under the credit crunch.

Lower rates might help, but experts sound increasingly anxious about the state of the U.S. economy. Several cited a slowdown in other economies, from Asia and Australia to Europe. That threatens to cloud over the rare bright spot in the U.S. economy—strong exports overseas by American companies.

"You've got downward pressure from labor markets…but no identifiable offset from other sectors of the economy," says Hembre. He cites weak stock and credit markets, a continuing financial and housing crisis, low confidence among business executives, and local and state governments squeezed by declining tax revenue.

As recent job figures show, the U.S. economy finds itself in increasingly choppy waters—and no lifelines within easy reach.

Steverman is a reporter for BusinessWeek's Investing channel.