Recent economic data, especially since mid-March, has taken a turn for the worse. Initial jobless claims have shown fluctuations that defied seasonal adjustment processes.
Just as I (accurately) suggested last month, it is a time for caution.
I will elaborate on my reasoning in the conclusion, but let us first review the expectations for Friday's report.
My 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. I sift through the mythology and the mistaken conventional wisdom.
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.
For the full explanation please read this former preview. You will enjoy a laugh along with a deeper look.
Three months ago I recommended that readers should compare the results of the various forecasters, viewing the BLS as a competitor along with others. At some point we know the actual result, so why not consider all of the forecasts. We now have more results, reported in the conclusion.
My main point is simple, but important.
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 April.
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 +/- 100K 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 30K jobs per month overall, and 35k jobs per month on private employment. The January report adjusted for these benchmark revisions.
- Early returns suggest that the BLS methods might be running too high by as much as 65,000 per month. See the conclusion.
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 119K private jobs on a seasonally adjusted basis. In general, the ADP results correlate well with the final data from the BLS, but not always with 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. Their idea is that this is the best current method for determining real job growth. TrimTabs forecasts a gain of 67K. 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 about 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 model is still officially on the sidelines, it once again 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 100K 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 155K, while their own forecast is for 135K. Their private jobs forecast is about 10-20K higher, since the loss of public jobs is a continuing drag.
- Gallup has an update to an employment series without seasonal adjustment. They have not been consistently reporting a series that we can follow. 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 US economy creates over 6.5 million jobs every quarter.
- Failure to recognize sampling error. The payroll number has a confidence interval of +/- 105K jobs. The household survey is +/- 450K 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 under-estimating new job creation, which was demonstrated in the addition of 350K 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.
The first table shows the data from January. The actual net job gain for the quarter was 582K. All of the estimates were too low, and the BLS was the worst.
Original Employment Estimates - Q2 2012
Original Employment Estimates - Q3 2012
The second table shows the original estimates from various sources for Q3 2012. We now know from the just announced QCEW report that all of the estimates were much too high. The overall net job growth for the quarter was only 199K - very poor. This time, the BLS was the best, but still very much too high.
Trading and Investment Conclusion
For traders, this should be a time of caution. The economic data suggest that this could be a very weak number - possibly even a negative print given the 100K error band. Readers should ignore any speculation that the Fed knew the number when meeting this week.
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. Their man on the Chicago trading floor can be relied upon to convey these interpretations. He has the back of the bears, so we should all take advantage of this knowledge.
For investors, the story is a bit different. If you look broadly at all of the data, you should expect a report that is consistent with the sluggish growth we see in other reports.
For most of my accounts I am exercising caution in front of the data, and hoping for some good opportunities during the day on Friday.