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Labor Pains
Toronto: August 11, 2014
By John Stephenson

U.S. stocks rallied to pull the Dow industrials into positive territory for the week, after news service Interfax reported Russia had ended military exercises near the Ukraine. While much of the buying was short-term oriented traders such as hedge funds closing out defensive positions from earlier in the week, this was welcome news. The U.S. economy also showed signs of life with the second quarter gross domestic product (GDP) coming in at 4% and the July Institute of Supply Management (ISM) recording a three-year high of 57.1.

The strong second quarter economic growth has once again ignited the discussion over when the Fed will begin raising interest rates. For the Yellen Fed, it’s all about jobs and in particular full employment, which will be the key determinant for when the Fed begins its move. While the tumble in the U.S. unemployment rate from 7.3% to 6.2% has been impressive, there’s still much more to do on the employment front.

For starters, there’s still plenty of slack in the labor market with some seven and a half million Americans that are counted in the ranks of the employed because they have a part-time job, but are willing to work full-time if such a job were in the offing. Then there is the million and a half more Americans that are counted as if they are out of the labor market but would work if they could find a job.

With so much slack in the U.S. workforce it might be tempting to conclude that Fed hikes are a long way off, but labor market slack can disappear in a hurry once hiring heats up.

One reason for optimism on the jobs front is that the ratio of openings to hiring is well above the historic norms, suggesting that hiring will soon follow. This is a good sign and one which is further collaborated by the data on the average number of hours worked, which shows that businesses are making their employees work longer hours—a precursor to eventual hiring. In fact, if the openings to hiring ratio were to revert to its historic average, that alone could drop the U.S. jobless rate to 5.7%.

With strong economic data and hiring likely to pick up, it might not be long before the Fed begins to raise interest rates. While a rising interest rate environment will be an initial shock to the stock market it does signal that better economic conditions have arrived. While the Fed appears to be on hold for now, look for the Fed to begin hiking rates in the first half of 2015.

That’s not the only change investors are fretting about, as many investors have become increasingly worried about the recent lagging performance of small-cap stocks. For some, this is cause for concern, as there is a longstanding belief among investors that a true bull market requires the participation of small cap names.

It’s typical for small caps to outperform in the early stages of a bull market as risk-seeking investors rush to grab profits in the areas that were hardest hit during the bear market or recession. Small caps have been on an impressive run since 2000 and with the recent pullback in the small cap space many investors have been spooked. But nowadays the small caps are trading at a significant premium to the S&P 500, making them less of a bargain than they were previously. Over time, the market quite normally starts to put a greater premium on quality and this is particularly true when small cap valuations are above those of large cap stocks.

This doesn’t suggest the end of the bull market but rather a transition in leadership from small cap to large cap. Historical data has also shown that over short time frames a sluggish small-cap index is a negative for stocks, but over longer periods of time the stock market does better when small-cap stocks are underperforming.

I’m waiting on the slow fat pitch down the center of the plate to begin adding to my positions and am looking toward the industrial sector for much of that alpha, which has pulled back some 6.5% since early June. This pullback in industrials has occurred despite the benefit of improving earnings estimates, company data coupled with strong U.S. economic data.

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