For the next few days, the market will likely be laser-focused on the labor report due from the Bureau of Labor Statistics (BLS) this Friday morning. Analysts expect the report to show a loss of 8 million jobs through May. That would be much greater than the 2.7 million private payrolls decline reported by ADP yesterday morning.
The issue for the market is not whether the unemployment rate hits 20% or not, but whether job losses are slowing more or less rapidly than expected.
If the BLS report follows the ADP report, showing a lower-than-expected decline, we could be in for a nice surprise.
However, the report could easily pull the market down. The recovery in commodity prices — especially oil — is one of the main factors preserving stability in the stock market. Labor and commodity prices are two sides of the same coin in many ways. So, any unexpected weakness in labor could trigger a sharp correction in commodity prices and transitively, the major stock indices.
A Look at the Oil Prices
As you can see in the following chart, oil prices have risen by 203.4% since the rally began on April 28. Similarly, oil stocks have risen by 74.3% since they formed a bottom in March, which is important for stock prices in the rest of the market.
Daily Chart of Crude Oil Futures and the Energy Select Sector SPDR Fund (XLE)
For example, there is a strong connection between the health of the oil sector and the health of financial stocks. Regional bank stocks tie in because of their lending to local oil companies, oil employees and related industries. The consumer discretionary, housing and services sectors have a similar relationship with the energy sector because of this connection to the labor market.
If the labor report shows more job losses than the 8 million expected, the recovery in oil prices may be in danger. We feel this is worth focusing on right now — despite the positive surprise in the ADP report — because of the negative surprise from the manufacturing PMI report released on Monday.
According to the Institute for Supply Management (ISM), the manufacturing Purchasing Manager’s Index (PMI) was 43.1. This was slightly lower than expected and could indicate a recession.
While manufacturing represents a much smaller percentage of the U.S. economy than services, it has a ripple effect. This effect amplifies its influence beyond its proportional percentage of overall economic activity.
The decline in the manufacturing PMI had already started before the end of 2019, which we believe was one of the best indications that stocks were overvalued before the pandemic worsened. It may also be the reason the market declined so much after the spread of the disease accelerated.
Because market risks are centered in manufacturing, industrials and commodities, we have avoided those sectors when looking for new positions. We will likely continue to do so in the summer months.
Taking a Look at the Bright Side
However, the bright side of this mixed outlook is that it lowers earnings expectations. Extremely low expectations are easier to beat. We think the odds of positive earnings surprises this quarter are starting to rise.
For example, annual earnings per share estimates for the S&P 500 for 2020 are down 28% but the pace of that decline has slowed considerably. According to FactSet, the average decline in earnings expectations in March was $3.91 per week. That pace has slowed to 15 cents per week over the past week.
Daily Chart of the Technology Select Sector SPDR Fund (XLK), Health Care Select Sector SPDR Fund (XLV) and Energy Select Sector SPDR Fund (XLE)
Most of that slowing decline can be attributed to the stable outlook for healthcare, information technology and energy stocks. This is one of the big reasons we have had such a focus on tech stocks in the portfolio, including opening a new position in Microsoft (NASDAQ:MSFT) last week.
It is also why we believe the market will be watching Friday’s labor report. We expect to maintain our focus on the most stable sectors over the next several weeks. Because the market outlook has been so negative, sectors with improving or stable expectations are more likely to attract new buyers and avoid selloffs if we see more volatility following the labor report.
Are the Protests Against Police Violence a Problem for the Market?
Although we don’t expect the economic impact to be long term, we need to address the potential risks created by the recent protests in major cities around the country.
Diverse crowds have gathered to protest police violence and the death of George Floyd in Minneapolis on May 25. In some cases, these protests have been accompanied by bad actors willing to use outrage to vandalize, steal and loot. The press has widely covered this.
Does civil unrest like this affect the market? As you might imagine, the answer is “yes and no.” It depends on the breadth and duration of the protests. However, recent historical examples in the U.S. suggest that protests are not a short-term factor for the market.
For example, the 1992 Rodney King riots and protests centered in Los Angeles County left the S&P 500 unchanged. The 1968 protests and riots centered in Washington D.C. happened while the Dow Jones Industrial Average gained 4%. And even the riots and protests in Ferguson, Missouri in 2014 couldn’t slow a 5% gain in the S&P 500. I selected these three examples because they are familiar to most investors. But a larger sample set doesn’t change the conclusion.
Certainly, the situation can worsen. But we think the potential for these protests to affect the market like the protests in Greece in 2011 is unlikely. What we can usually anticipate is a short-lived rally in gun stocks — like Sturm, Ruger & Company (NYSE:RGR) or Smith & Wesson Brands (NASDAQ:AOBC) — which will evaporate as the focus of the protests shifts toward political action and the upcoming national election.
The Bottom Line
The labor report on Friday will provide a lot more clarity for investors. The potential for a negative surprise seems low, but stocks are probably a little overextended to the upside right now. So, some volatility following the report is possible as investors “sell the news” and take some profits off the table.
However, beyond the labor report, we don’t see many other factors that would destabilize prices. The only one that comes to mind is an unexpected resurgence of Covid-19 infections.
While we still feel it is extremely unlikely for the S&P 500 to challenge its pre-pandemic highs this quarter, we consider a flat trend to be the worst-case scenario in the short term. This should be a good market environment for option sellers like us.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.