Once again, the monthly payroll report has a special significance. I am cautious for several reasons:
- The market rally is generally perceived as extended -- many are looking for a reason to sell.
- The recent economic data has shown signs of weakness, possibly affecting consumption and business formation.
- There is a ceiling on strength, due to incorrect assumptions about the Fed.
I will elaborate on each point in the conclusion, but let's first review the expectations for Friday's report.
This preview is different. There are many concepts and facts that you will not see anywhere else. I also try to provide an angle both for traders and investors. There is an element of truth (what will eventually become clear) and an element of buzz (what will draw exaggerated attention Friday morning).
For many years I have written a regular monthly preview of the Employment Situation Report. I have done extensive research on all of the methods and even visited the stat guys at the BLS to discuss their approach. My preview gives appropriate respect to the BLS, but also to the leading alternative methods. My best analogy was to a bean-counting contest. The winner was not the contestant who was closest to the correct answer. Instead, the winner had to predict the guess of a fellow contestant.
This is what we do every month. We want to know the truth about the economy. Instead of recognizing that there are several good estimates, everyone tries to guess what the BLS will report. Please read this prior preview both for a laugh and a deeper look.
Recently I did something extra, reviewing the most recent period for which we have actual data and showing who had the best estimate. There were three conclusions:
- All of the estimates were too low.
- The much-maligned ADP was the best, and that missed by more than 100,000 jobs.
- The BLS methods were the worst.
We rely far too much on the first pass, BLS version, and officially certified monthly employment report. It is a natural mistake. We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets. Whenever there is an important question, we all seize on any available information. While we might know the limitations of the data, any concern is briefly acknowledged -- if at all -- and then swiftly put aside.
We would like to know the net addition of jobs in the month of March. To provide an estimate of monthly job changes, the BLS has a complex methodology that includes the following steps:
- An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not), the sampling error alone for a 90% confidence interval is +/- 100,000 jobs.
- The report is revised to reflect additional responses over the next two months.
- There is an adjustment to account for job creation -- much maligned and misunderstood by nearly everyone. Everyone focuses on the birth/death adjustment. This actually accounts for less than 20% of the BLS attempt to estimate job creation.
- The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low, as revealed in the most recent report. For the year ending in March 2012, the BLS estimate was off by about 30,000 jobs per month overall, and 35,000 jobs per month on private employment. The January report adjusted for these benchmark revisions.
The BLS report is really an initial estimate, not the ultimate answer. The BLS is actually like one of the contestants, with the full report coming later. The market uses this estimate as "official" and declares winners and losers on that basis. No one pays any attention to the final data, which we do not see for eight months or so.
- ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 158,000 private jobs on a seasonally adjusted basis. In general, the ADP results correlate well with the final data from the BLS, but not always the initial estimate. In recent months ADP is using an improved methodology with a stronger sample. The objective is to improve the correlation with the final print of the employment data.
- TrimTabs looks at income tax withholding data. Its idea is that this is the best current method for determining real job growth. TrimTabs forecasts a gain of 156,000. We are moving past the year-end uncertainty about tax law from the fiscal cliff debate, so one would think that the TrimTabs estimate would now be more accurate.
- Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating -- you should make an independent estimate).
- Jeff Method. I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011, the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. This is on the summer research agenda -- a time when I typically have help from smart people looking for great experience. While the Jeff Method is still officially on the sidelines, it suggests significantly lower job gains than the other approaches. Put another way, on a long-term historical basis we would not expect gains of more than 100,000 given the other economic data. Is job growth really leading the recovery? I do not think we have a good grasp on job creation. The BLS tries hard, but their approach lags on this front. Street estimates are generally similar to my method, but few reveal much about the specific approach. These estimates usually adjust for the ADP report.
- Briefing.com cites the consensus estimate as 192,000, while its own forecast is for 185,000. Its private jobs forecast is about 15,000-25,000 higher, since the loss of public jobs is a continuing drag.
- Gallup does not seem to have an update to its unemployment series. I have tried to give this source respect and equal time despite a rather overt bearish and political approach in past commentaries. Why no update on seasonally adjusted unemployment?
Failures of Understanding
There is a list of repeated monthly mistakes by the assembled jobs punditry:
- Focus on net job creation. This is the most important. The big story is the teeming stew of job gains and losses. It is never mentioned on employment Friday. The U.S. economy creates over 7 million jobs every quarter.
- Failure to recognize sampling error. The payroll number has a confidence interval of +/- 105,000 jobs. The household survey is +/- 450,000 jobs. We take small deviations from expectations too seriously -- far too seriously.
- False emphasis on "the internals." Pundits pontificate on various sub-categories of the report, assuming laser-like accuracy. In fact, the sampling error (not to mention revisions and non-sampling error) in these categories is huge.
- Negative spin on the BLS methods. There is a routine monthly question about how many payroll jobs were added by the BLS birth/death adjustment. This is a propaganda war that seems to have ended years ago with a huge bearish spin. For anyone who really wants to know, the BLS methods have been underestimating new job creation, which was demonstrated in the addition of 350,000 additional jobs in the benchmark year.
It would be a refreshing change if your top news sources featured any of these ideas, but don't hold your breath! And, most importantly, it would be helpful if anyone would realize that the BLS is just one estimate among others -- and perhaps not the best. The bean counter example illustrates this.
In my experience, it has usually been safe to be conservative in front of this report. The story is so complex that it is pretty easy to generate a negative spin. Your favorite perma-bear/conspiracy site does a good job of preparing. It is poised to comment on seasonal adjustment, birth/death adjustment, labor force participation, hours worked, and discrepancies between the payroll and household surveys.
Here are some fearless forecasts from the Old Prof:
- Based on my indicators, I am especially worried about this month's report.
- Much will be made of seasonal adjustments - - mostly by those who have never produced a dataset that included any seasonal adjusting.
- No one will recognize that the BLS estimate is just that --- an estimate. We already know most of the answer, and it is pretty good.
- Any extreme result will get an exaggerated interpretation. If the job growth were to be 50,000, we will have claims that recession is upon us. If the BLS estimate is 300,000, we will hear that the Fed is about to tighten rates.
- Watch the "hours worked." This could be an early indicator of employment weakness.
As usual, the number is less important than everyone thinks. So here is the most important point:
The Fed will not change policy based on the March employment report-no matter what the outcome. Everything that I have written here is completely understood by the FOMC. It will take a long series of results to influence Fed policy. Since traders and pundits do not seem to grasp this, the wise investor may get (yet another) opportunity.