By Jack Hough
America’s employers added 243,000 jobs in January, reducing the headline unemployment rate to 8.3%. That rate is too high for comfort, but it’s the lowest it has been in nearly three years.
That ought to be good for stocks. After all, workers are also customers. Jobs bring pay, which fuels spending and drives corporate revenues higher.
But in the short term, more hiring might cause stocks to stall rather than soar, says Jeff Kleintop, chief market strategist at LPL Financial, an investment services firm.
That’s because the sharp run-up in stock prices since the recession ended in mid-2009 has been driven by a similarly sharp run-up in corporate profits. For the S&P 500 index, trailing operating earnings nearly doubled between the fourth quarter of 2008 and the fourth quarter of 2011. And the index price has slightly more than doubled since hitting its March 2009 low.
The profits came from cutting back rather than expanding. As companies cut jobs in 2008 and 2009, the result was a surge in what economists call worker productivity, and what employees call splitting more work among fewer people.
Labor accounts for around 70% of the costs of a typical large company outside of the energy and mining sectors. So by skimping on hiring, companies have allowed more of their revenues to fall to the bottom line as profits.
“Everything has been to the benefit of corporations,” says Mr. Kleintop. “But now the balance is shifting.”
Growth in labor productivity slowed from 4.1% in 2010 to 0.7% last year. Fewer companies are beating Wall Street’s earnings forecasts than usual, and more are cutting their earnings guidance.
For the S&P 500, earnings are projected to increase 9% this year, down from 15% last year and 47% in 2010. The index has already surged 8% for the year, leaving little room for it to increase in tandem with coming earnings.
Barring some unseen source of faster earnings growth, one of two things should happen next. Either the market becomes more expensive relative to earnings or it pauses until earnings catch up.The S&P 500 is already trading at 14 times trailing earnings, which is close to its historic average.
The good news is that with productivity gains slowing, earnings growth may have to come from hiring rather than at the expense of it. In the long run that should create more prosperity and higher stock prices. For now, Mr. Kleintop recommends avoiding sectors of the market where prices look stretched and earnings growth is minimal, like utilities and telecoms, and favoring sectors where prices are reasonable and earnings growth remains robust, like manufacturing and technology (see Tech Stocks: Safer Than You Think).
Investors can get exposure to those using the Industrial Select Sector SPDR (XLI) and the Vanguard Information Technology ETF (VGT).