The December jobs report from the Bureau of Labor Statistics - which showed that the economy had added 155,000 jobs - was greeted by a chorus of analysts proclaiming that the employment picture was on the mend and would likely accelerate in coming months.
But what if, for this cycle, the current employment picture is as good as it gets and will either remain stuck in low gear or take another cyclical turn for the worse before it gets better? I believe this to be the case, with negative implications for U.S. stocks (SPY).
Oh Lord, Stuck in Low-Gear Again
The party line for strategists seems to be that payrolls have yet to truly recover from the Great Contraction and that they are just waiting for the chance to "hockey-stick" upward. By contrast, the chart below shows that they actually have recovered, just to a low level that is roughly equivalent with the "jobless recovery" following the bursting of the tech bubble in 1999-2000.
Following an initial strong recovery to a 3-month sum of just under 1,000,000 jobs by May 2010, the monthly change in payrolls has averaged just over 123,000 jobs. During the previous cycle, the monthly change in payrolls only averaged 157,000 jobs from September 2003 through the end of 2007. Both cycles were far below the 1992-99 cycle, when payroll growth averaged 232,000 jobs per month.
Similarly unencouraging, weekly jobless claims also have plateaued at a relatively high level (see chart below).
Deteriorating Labor Market Fundamentals
Sluggishness in the labor market is a reflection of deteriorating fundamentals that have reversed some of the gains of the previous 30 years. The U.S. labor market led a charmed life during the 1980s and 90s. The service economy in the U.S. gained steam, growing to over 80% of total non-farm payrolls by 1999, while the percentage of women in the workforce grew from under 40% to nearly 50% (see chart below).
The net-effect was a dramatic increase in both the labor force participation rate, or the ratio of the labor force to the civilian, non-institutional adult population, and the employment to population ratio, or the ratio of total payrolls to the same population. This increase in the labor force, at the same time that productivity improved due to technological advances, led to significant strong economic growth and significant increases in prosperity.
Unfortunately, both ratios have declined significantly since 2007, with the employment-to-population ratio falling to levels last seen in the late 1970s. (see chart below)
Net-net, the labor force is 5.76 million workers smaller today - with the participation rate of 63.6% as of December 2012 - than it would be at the 2007 participation rate of 66%.
The Heritage Foundation analyzed micro-data from the Bureau of Labor Statistics in early 2012 to determine why people were leaving the workforce. On the positive side, they found that about 46% of the decline in labor force participation could be attributed to people attending school - positive for the human capital of the economy - and about 22% could be attributed to changes in demographics, such as the retirement of the vanguard of the baby-boomer generation.
The other 33% of the decline in labor force participation, though, was due to an increase in the proportion of workers collecting disability insurance, despite the fact that the nation as a whole actually got healthier over the period studied. Given that less than one-tenth of workers leave the disability system to return to the workforce, this development is negative for the economy to the extent that these workers might have been able to continue working in an environment with more job opportunities. Indeed, the job creation engine of the economy seems to be broken; while cumulative payroll changes over the past three years have been enough to keep up with the greatly diminished labor force, they are not even close to keeping up with the population (see chart below).
Sadly, the decline in job creation has disproportionately affected economically vulnerable populations, such as the young, people of color, and those with less education.
So, where have all the opportunities gone? The next two charts look at the breakdown of a 1-year rolling sum in payroll changes by major categories - private vs. government and manufacturing vs. services. The first chart shows that government downsizing has been a major factor in the current sluggish employment picture, while private hiring has also been quite weak, never really making it about 2,000,000 jobs per year on a rolling basis since the 2007-08 financial crisis and recession. Indeed, only two recoveries since 1940 - in the early 1960s and the early 1980s - have seen a slower pace of private job creation in absolute terms.
The next chart shows a deterioration in the job-creation ability of the service economy, which makes up nearly 90% of total non-farm payrolls. Indeed, the pace of job creation in the service sector has slowed in each of the last four recoveries, even as manufacturing job creation during periods of recovery has held relatively stable (albeit at a low level compared to history).
Leading indicators do not look pretty, as well, for either manufacturing or service sectors. The New Orders index has been leading the Employment index lower for both the ISM Manufacturing and Non-Manufacturing Purchasing Managers Indices since early 2010 (see charts below). While New Orders have improved marginally in the last couple of releases, the downtrend in both sectors looks intact and eerily similar to the mid-2000s.
The downtrend in New Orders and Employment indices is a sinister development, since the ISM Manufacturing Employment index has a coincident correlation of 0.78 with the 3-month percentage change in payrolls since the late 1940s (see chart below).
Conclusion: Implications Not Good for Stocks
While this time could be different and payrolls could improve significantly from here, I doubt it. The 2% payroll tax increase on workers - especially on those lower income workers with the highest marginal propensity to spend - and upcoming spending cuts are not positive developments for economic growth and the labor market, even if they are arguably necessary steps for the long-term fiscal health of the country. Indeed, the IMF found recently that the "fiscal multiplier" governing the transmission of fiscal austerity to economic growth was much higher than originally thought, coming in between 0.9x - 1.7x, versus expectations of about 0.5x, suggesting that the negative effects of austerity on growth may be significantly greater than the simple sum of tax increases or spending cuts.
The long-hoped for upward hockey-stick in payroll growth may not actually happen before the next recession, which has negative implications for equities. Payroll growth as a percentage of total payrolls has been negatively correlated with future, 1-year stock market returns over the past 60 years (see chart below).
Indeed, while some are calling for the coming panacea of growth and employment to usher in a new secular bull market in stocks, that development would be rather early when compared to the previous two secular bear markets (see chart below).
The current secular bear has been tracking its predecessors relatively closely, with inflation adjusted returns achieving a 0.66 correlation with the progress of the Great Depression bear market and a 0.40 correlation with the progress of the Great Inflation bear market of the 1960s-70s.
I believe that a further leg down is likely for both payrolls and stocks in coming months. The potential triggers for such a downturn include the 2% payroll tax increase in the U.S. which has already gone into effect and has started to bite into workers' paychecks, a messy debt ceiling fight in the U.S. Congress, losses at the polls for pro-euro parties in Europe (click here for an interesting commentary on Europe) or, paradoxically, a rapid increase in Treasury yields in the U.S., putting stress on bank balance sheets through mark-to-market losses.
In terms of timing, the current deterioration in market breadth suggests to me that the distance to the market top may be measured in months, not in years. Indeed, the High-Low Index for the S&P 500 has made a steady series of lower peaks over the last two years, reminiscent of the 2007 market top (see chart below).
This "bearish divergence" is echoed in the RSI and MACD readings for the weekly S&P 500 chart as well (see chart below).
While I do not advocate risk-on/risk-off market timing, I would recommend diversifying across sources of return that do relatively well in bad times, such as the momentum and trend-following strategies that I discussed in more detail in the text and comments of my recent article, False Prophets.