The US Unemployment Rate moved down to 3.6% in March, its lowest level since the start of the pandemic and well below the historical average of 5.75%.

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If you asked most people, they would probably say this is a bullish sign, where a strong economy is good news for the stock market. But is this actually the case? Let’s take a look…

We have data on the Unemployment Rate going back to 1948. Historically, the best future returns for stocks have come after the highest unemployment rates, and the worst future returns for stocks have come after the lowest unemployment rates. We also see highest odds of a positive return following high unemployment rates and the lowest odds after low unemployment rates.

Note: we are currently in Quintile 5 with an Unemployment Rate of 3.6%.

What’s driving this counterintuitive relationship?

Valuation.

On average, higher unemployment rates tend to be associated with lower valuations and vice versa.

Note: using the CAPE (Cyclically Adjusted P/E Ratio) ratio as a measure of S&P 500 valuation.

Why? Because when there’s good news in the economy (low unemployment), people are often willing to pay a higher multiple for a given level of earnings than when there’s bad news (high unemployment). That’s important when it comes to stocks because higher valuations tend to be associated with below average forward returns.

The S&P 500’s current valuation is in the 98th percentile, higher than every period in history with the exception of the late 1990s and early 2000s.

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Historically, the combination of higher valuations and lower unemployment rates has been particularly unfavorable for stocks, with below average returns in the following 1-year through 7-year periods.

Does that mean that the S&P 500 will have low returns going forward? Not necessarily. These are just probabilities and tendencies; there are always exceptions.

But it does mean that investors probably shouldn’t view a low Unemployment Rate as a bullish sign for stocks, particularly when it’s coupled with high valuations as it is today.