So Much for Autopilot. Now Active Investors Get a Turn.
What's good for workers is bad for investors. With one asterisk.
Signs of full employment -- like we got in Friday's jobs report with an unemployment rate of 4.6 percent -- are terrible news for passive investors but perhaps a ray of hope for those beleaguered active investors.
Over the course of any business cycle, investors benefit the most in the beginning, while workers do better toward the end. The long bull market that began in August 1982 coincided with an unemployment rate of 9.8 percent. When the dot-com boom peaked in March 2000, the unemployment rate was 4.0 percent. Similarly, in this current cycle, the stock market bottomed in March 2009 when the unemployment rate was 8.7 percent. One of the reasons this expansion has lasted so long is that it has taken so long for workers to regain bargaining power.
But with the unemployment rate at 4.6 percent, we're there: Employees now have the most bargaining power that they've had in a decade -- and historically that's been a terrible sign for stocks. Since 1950, there have been four other cycles in which the unemployment rate got as low as 4.6 percent. Those months were May 1965, October 1973, November 1997 and May 2006.
People who invested in the S&P 500 in the 1973 and 2006 periods would have been disappointed to find that more than five years later, stocks could have been bought at nearly the same prices. For buyers in 1965 and 1997, the news was even worse -- stocks could have been bought at similar prices over a decade later. This doesn't account for dividends, and this doesn't mean that stocks didn't go higher at some point in between, but for long-term passive investors who bought in at this level of unemployment, their portfolios would have acted like "dead money" for 10 years or more.
Starting from this level of unemployment, from the standpoint of investors, more things can go wrong than can go right. Wage growth can exceed economic growth, putting pressure on corporate profit margins. Interest rates can rise, tightening financial conditions. Inflation can rise, putting more pressure on central bankers to remove liquidity from the system. Government spending's cost in the form of crowding out private economic activity can eclipse any stimulus impact. The economy can enter recession. About the only thing investors can root for is for leverage and valuations to increase, potentially turning into a speculative mania that then ends in a crash.
However, ultra-low unemployment like the U.S. is experiencing today can be great news for active investors. It gives them the conditions to beat their benchmarks, which are much lower hurdles to beat than in the early investor-friendly stage of an expansion. The glory days for hedge funds were between the late 1990s, when the economy was at full employment and the stock market was entering its bubble, and the late 2000s, during the financial crisis. During this long expansion, hedge funds and other active investors have struggled, as booming equity markets, perpetually low interest rates, and little change in fiscal or monetary policy have made it tough to beat a passive benchmark.
Consider the following scenario over the next five years. Chronic labor shortages. Profit-crunching above-trend wage growth. Higher inflation and interest rates. Poorly-designed fiscal stimulus that dampens real economic growth. Damaging immigration restrictions. A trade war. The prospect of a Trump administration that haphazardly picks winners and losers in response to populist sentiment. A recession resulting from Federal Reserve interest rate increases. This might cause ulcers for passive index investors, but it's exactly the kind of environment that will create some big winners among active investors.
Passive investors have had reason to gloat ever since the recession ended. Now, as workers and active investors rejoice, the passive investor's pain is about to begin.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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