James Paulsen, chief investment strategist at Wells Capital Management, suggests that low unemployment is likely to precipitate decline in U.S. stocks and bonds.  “Post-war history suggests investors should prepare for a much more challenging market risk-and-reward environment during the balance of this recovery,” he says.  The key problem is that the demand for labor, reflected in 2.3% GDP growth, is higher than labor supply growth, which Paulsen measures at 2%.

The unemployment rate is near 5%.  Historically, an unemployment rate of 5% or lower has generally correlated with:

• Annual stock returns declining by about 50%;

• Annual bond returns declining by about 75%;

• More frequent monthly declines in both stocks; and

• A recession within 1.8 years, on average.

Some other observers agree with Paulsen.  Ed Yardeni of Yardeni Research says, “The biggest problem facing the economy may actually be a shortage of workers with the right skills to fill the record number of job openings.”

Two Fed governors disagree. Fed Gov. Daniel Tarullo said that the historical correlation cited by Paulsen hasn’t been working for the last 10 years.  He suggested, “it’s probably wise not to be counting so much on past correlations.”

Paulsen is not predicting imminent U.S. recession.  Instead, he suggests lower returns, more frequent declines, and higher risk of recession are probable.  One way for investors to reduce the effect on their portfolios may be to shift toward European and emerging market investments.