The S&P 500 is approaching a record high, despite signs of a weakening labor market. Job growth has decelerated significantly, dropping from 158,000 in April to just 22,000 in August. In contrast, the S&P 500 has achieved 21 new highs during this period.

This divergence between soaring stock prices and sluggish labor data has sparked concerns among investors. Equities seem to be anticipating a rebound in economic activity by 2026, while expected Federal Reserve easing at next week’s September FOMC meeting has further bolstered market optimism.

A cooling labor market may also provide a tailwind for corporate profits. Profit margins typically reflect the difference between prices and input costs, including labor expenses. The GS Wage Growth Tracker currently stands at 4.0%, with leading indicators suggesting a slowdown to 3.3%.

Labor costs account for 12% of revenues at the aggregate S&P 500 index level, with the median stock reporting labor costs equal to 14% of revenues. Sector-specific variations are notable, ranging from Industrials at 20% to Energy at just 4%. These estimates are derived from company-reported data on employee numbers and median compensation.

A 100 basis-point change in labor cost growth could impact S&P 500 earnings per share (EPS) by 0.7%, assuming other factors remain unchanged. The sensitivity of earnings to labor costs varies based on revenue growth and profit margins. Small-cap stocks, which typically have lower profit margins, are more vulnerable to shifts in labor costs. For instance, a 100 basis-point change in labor cost growth would affect Russell 2000 EPS by 1.5%, all else equal.

Intra-market rotations reflect optimism regarding the labor market slowdown. Stocks with lower labor costs (tracked by GSTHLLAB) have outperformed those with higher labor costs (GSTHHLAB) by 8 percentage points year-to-date. Investors appear confident that the recent labor market weakness is temporary.

Sector-neutral labor cost baskets have been rebalanced. The median low labor cost stock has labor costs equal to 6% of revenues, trades at a next-twelve-month price-to-earnings (NTM P/E) ratio of 18x, and is projected to achieve 13% EPS growth by 2026. Meanwhile, the median high labor cost stock has labor costs equal to 32% of revenues, trades at an NTM P/E of 21x, and is also expected to grow EPS by 13% by 2026.

We leverage labor cost data to assess the potential impact of AI on corporate earnings. Firms with high labor costs, significant AI exposure, and narrow profit margins stand to gain the most from AI-driven productivity improvements. Notably, ten stocks appear in both our High Labor Cost basket and AI Productivity basket (GSTHLTAI): Accenture (ACN), Aon (AON), Brown & Brown (BRO), CrowdStrike (CRWD), Cognizant Technology Solutions (CTSH), Dollar Tree (DLTR), DaVita (DVA), EPAM Systems (EPAM), Marsh & McLennan (MMC), and News Corp (NWSA).