The worst monthly jobs report since June caught investors by surprise on Friday and knocked the market down more than one percent before rallying in the last hour of trading Friday to cut the loss by more than half. The rally off the lows is not surprising given the amount of managers that find themselves significantly behind the performance of their benchmarks and were waiting for any pull back to deploy cash. However, we are likely to have many more down days in the near future that will provide even better entry points to put new funds to work.
I have been skeptical of this rally for weeks as to me it was shaping up as another early false start to the year much like the rallies early in 2011 and 2012 that faded out around this time of the year. There are a litany of factors that could disrupt equities including the ongoing contraction in Europe, uncertainty about the strength of the Chinese recovery, changes at some to point to Federal Reserve policies, ongoing political posturing and even more noise from the Axis of Evil with Syria filling in for original member, Iraq. However the biggest worries investors should be focusing on right now are around Job Growth & Earnings.
Job Growth -
I was already highly doubtful the 200,000 monthly jobs we were averaging over the previous three jobs reports was sustainable even before Friday's dismal report on the job market. As noted in this recent article, I noted this was over 75,000 less jobs/month than at the same point in 2012 where job growth also started to decline badly around this time last year. In addition, 2012 did not have to contend with the implementation of the Affordable Care Act, the payroll tax holiday expiration or scaremongering around the cuts (minor) that are coming as the result of the sequester.
After Friday's jobs report we are even further behind 2012's job creation pace (See Chart) and I see little on the horizon that will accelerate job growth. The sequester cuts have not even hit and headwinds as a consequence to the Affordable Care Act are likely to accelerate through its yearend implementation.
One of the most disappointing things about the March Jobs picture is that 496,000 individuals dropped out of the workforce while private sector employment only grew by 95,000. This means that over 5 people are dropping out of the workforce for every person that finds a new job. This is hardly a healthy development and one unfortunately that has been present since the start of the recovery. Labor force participation has been dropping for several years (See Chart). Almost the entire improvement in the unemployment rate over the past four years is due to this drop as we have averaged just over 110,000 jobs/month since the beginning of the recovery which is barely enough to keep up with population growth.
It is true that as the Baby Boom generation ages, retirements are on the uptick. However, this only explains a minor part of the labor force drop-off. There seems to be a significant mismatch between the skillsets of job seekers and a good portion of middle class jobs that are open. In addition, thanks to the huge expansion of welfare eligibility, jobless benefits, food stamps…etc.., over the last four years, there are some huge disincentives for the out of work to take low wage jobs. Finally, the disability rolls have increased dramatically as the long term unemployed use (or abuse depending on your perspective) disability programs as a sort of permanent jobless program.
Businesses are also reluctant to hire for a variety of reasons. End demand is still tepid and the Affordable Care Act is a large disincentive to get past 50 employees for small business. Political uncertainty, new regulations and a populist bent to the country's political rhetoric hardly instills confidence either. Finally, one of the ironic twists of the Federal Reserve policies to lower interest rates throughout the economy is that it is cheaper to finance equipment to increase automation than at about any in point in history.
One of the under the radar stories that the market seems to be ignoring is that 86 of the 500 S&P companies issued negative guidance for the first quarter, only 24 issued positive guidance (Alcoa kicks off the earnings season Monday). This is the highest negative ratio since Factset started tracking this metric in 2006. The closest negative quarter to this one was the third quarter of 2007, which was the beginning of a long stock slide. 7 of the top 10 stocks by market capitalization have had their consensus quarterly earnings estimates revised down since the start of the year with Apple (AAPL) leading the pack with a 17% decline in quarterly earnings estimates. Finally, a lot of the earnings growth analysts expect in the S&P this year is backend loaded (much higher estimated earnings growth in the 3rd and 4th quarters than in 1st QTR & 2nd QTR).
In summary, job growth is declining for logical reasons and we are unlikely to average more than the 200,000 monthly we were earlier in the year. Earnings growth is also suspect. Given that we gave up the early rallies in 2011 and 2012 and now face as much or greater headwinds this year, the odds are good history will repeat itself with the 2013 rally. Prudent investors should have at least 10% of their holdings in cash and have a shopping list of stocks they would love to pick up 5% to 10% cheaper. There is a good possibility that may just pick up some nice stocks at lower entry points in the months ahead.