By Michael Bailey, CFA
Many Americans are hoping for a happy new year after the economic and financial challenges of 2022, which included eye-watering inflation and a bear market. Careful what you wish for. In some ways, the choppy economic waters are already easing, but look beneath the surface and you’ll find a churning sea of emotions anchored to behavioral economics research and potential changes in the business cycle.
The punchline for the economy is that consumers dislike inflation, but they hate job losses even more. If inflation plummets and unemployment ticks up just a bit, will the economy stabilize? Or get full-on seasickness? Investors are struggling to understand these relationships as they try to avoid capsizing again in 2023.
Getting better and getting worse
What’s going on here, and how do we know if the economy’s improving? Americans are still fighting a nasty case of sticker shock as high demand crashes into supply shortages, driving inflation to multi-decade highs and crimping consumer budgets. That’s the bad news. The good news is that inflation appears to have peaked in June 2022. However, there’s more to the story.
One way to understand today’s economy may be to take a trip way back to the 1960s and examine an economic concept that Lyndon B. Johnson’s adviser, Arthur Okun, developed: The misery index. Okun combined inflation trends and the unemployment rate as a way of predicting voting patterns, with the idea that more miserable voters tend to throw the bums out, a risk for the party in power. Investors can also try to harness the predictive power of the misery index as they forecast consumer spending, profits, and stock prices.
So, what happened after Okun developed his miserable mashup of inflation and unemployment? Unfortunately for the U.S., the misery index, which averaged around 7% in the 1960s, began a long march toward supreme despair that reached a crescendo of 22% in mid-1980. That’s when the oil crisis and recession fueled sky-high inflation and above-average unemployment. Consumers were furious with high prices and job losses.
Let’s fast forward to the present and try to examine if the misery index can give investors any clues about economic and financial trends that may unfold this year. The misery index sits right around 11% currently, which is worse than a post-WWII average of 9%. However, just a few months ago, as gas prices blew through $5 a gallon, the misery index topped out at 13%. So things are getting better, but still worse than average. Investors are interested in what comes next.
Jobs, emotions, and consumer behavior
This brings us to the behavioral economics twist to the story. A steady job market and fading inflation have helped lower the misery index over the past six months. That’s good. And the consensus view among economists, according to Bloomberg research, is that annual inflation will plunge this year to about 4%, down from roughly 7% in late 2022. That’s also good.
However, economists also expect a gradual rise in unemployment to 4.4% in 2023, up slightly from 3.7% last year. That’s bad. But wait, if inflation goes way down and more than offsets a slight uptick in unemployment, then the misery index overall goes down and everybody’s happy, right?
Here’s the twist: Consumers are way more sensitive to changes in the job market, compared to price inflation. Think about it. Would you rather pay 20% more for gas or lose your livelihood? In fact, researchers have shown that people feel at least twice the pain from higher unemployment as they do from inflation.
An economist named Andrew Oswald published a study in 2001 that tracked happiness levels for 300,000 people and found that a 1% increase in unemployment had the same effect as a ~2% increase in inflation. What’s more, a study from another economist in 2014 found that rising unemployment was five times worse than rising inflation in terms of reducing happiness. This data supports the idea that jobs have a bigger impact on happiness than price movements. Oswald speculates that rising unemployment transmits a disturbing signal, even for those still holding a job.
If we go deeper into consumer psychology, perhaps we are really talking about how people feel the pain of losses. One of the ironclad rules of behavioral economics, according to Nobel laureate Richard Thaler, is that “losses hurt about twice as much as gains make you feel good,” a concept called loss aversion.
Perhaps the happiness research is suggesting that we need different scales for unemployment and inflation. Changes in inflation may feel like gaining or losing $50, while the same changes in unemployment may balloon up to the sensation of winning or losing $100, or even $250. This is the reason why Americans may feel more miserable this year if unemployment rises a little, even as inflation fades.
Picking apart the misery index: A guide for stock pickers
What are the implications for investors if a worsening job market more than offsets a reduction in sticker shock, tanking consumer happiness? Let’s turn to another Nobel prize winner in behavioral economics, Daniel Kahneman, who believes that “loss aversion is a powerful conservative force,” meaning that people become cautious as they anticipate losses. Kahneman adds that this trepidation around potential losses “favors minimal changes from the status quo in the lives of both institutions and individuals.”
Taking this a step further, we might argue that rising unemployment and loss aversion may lead consumers to retrench and focus on the basics, rather than trying something new or fun. This potential change in buying patterns may sound alarm bells for consumer discretionary sectors, while supporting more defensive consumer staples companies. While some of this bad news may already be built into parts of the discretionary sector, investors may want to tread lightly, especially with discretionary stocks trading closer to recent highs.
To be fair, investors may want to maintain some exposure to the discretionary sector within a diversified portfolio, especially for companies with scale, improving margins, and likely share gains in specialty retail, restaurants, and apparel, for example. Dumping consumer cyclicals in favor of defensive staples can be a short-sighted approach, especially if investors start to price in a full economic recovery and a major decline in the misery index.
Investors focusing only on the relationship between unemployment and consumer sectors might fall into another behavioral finance trap called narrow framing, which I outlined in my book “Stop. Think. Invest.” I argue that “because most people prefer to make easy, simple decisions…we generally prefer a narrow view of our choices. However, problems arise when we use this narrow frame because we often default to the least-risky option.”
Using a broad frame, we can put aside the narrow focus on consumer sectors and ask what other factors may drive investment performance in 2023, even if unemployment worsens. Let’s look at the data to see if there are other economic cycles that can give us a sense of how this year might play out.
In the early 1980s, inflation fell, but unemployment rose, setting up a test case of how consumers would respond as their happiness plummeted, similar to what we might see in 2023. In 1982, for example, unemployment spiked to nearly 11%, up from around 7% the year before, as inflation continued its gradual descent. The broader market had a ~13% drawdown by mid-1982, as job losses mounted, but then the clouds parted as stocks went on a tear and finished the year up about 20%.
Using this broader frame of consumer sectors and business cycles, we can take a bit more comfort in owning stocks this year, especially if we take the long view. Despite the gloom and doom of a bear market in 2022 and the risk of rising unemployment in 2023, there’s a good chance that this too shall pass.
Emotions and perceptions of gains and losses could lead to a contradiction this year if the misery index falls, while at the same time worsening unemployment leads to greater consumer misery. However, investors should take the long view as these ebbs and flows in the business cycle and sentiment might be merely a steppingstone to a full recovery.
About the author: Michael Bailey
Michael Bailey, CFA is the director of research and chair of the Investment Committee at FBB Capital Partners, a boutique Washington, D.C.-area, investing firm. At FBB, Michael is responsible for monitoring and analyzing macro and micro economic data, secular industry trends, and identifying appropriate investments for client portfolios. He is also the author of the investment and behavioral finance book, "Stop. Think. Invest."
FBB Capital Partners, LLC (FBB) is a SEC-registered investment advisor located in Bethesda, Maryland. Additional information, including our services, advisory fees and other helpful disclosures, can be found in our Form ADV Part 2, which is available upon request or on the SEC's website at www.adviserinfo.sec.gov.
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