By Joseph Hogue, CFA
One of the few times I can hear someone say, “this time is different,” without smirking is talking with other economists on the persistently high level of unemployment. Looking at employment levels through business cycles, we are definitely seeing a doggedly high rate well after the trough of the cycle. In fact, measuring months from employment cycle peak, this is the only recession where we have not returned to zero net job losses by this time in the cycle back to 1948. Forty-four months after the cycle peak, employment is still at five percent below its pre-recession level. Perhaps the most impressive statistic is the average duration of unemployment. The Bureau of Labor Statistics (BLS) reports that the August number topped out at 40.3 weeks while at no time since before 1980 has the number reached above 23 weeks. This kind of structural and long-term unemployment will have different effects for different sectors and investors should develop their portfolio allocations accordingly.
Speaking of the high level of unemployment is really something of a gross generalization. The unemployment rate for those with a high school diploma or less is above ten percent while that of someone with at least a bachelor’s degree is only a little over four percent. Additionally, we are seeing greater persistence in the unemployment of the less educated relative to the higher degree levels than in other recessions. The theme can be seen in unemployment rates by industry as presented in the graph below. At the height of the recession, unemployment in construction was more than twice the average and almost four times that of professional & technical services.
Before all these statistics put you to sleep, there is a point here. Over the short-term, and during past economic cycles, unemployed workers have a strong sense of their value in the workplace. Their expenses are fairly stable and they have some savings, so the wage at which they will return to work is roughly that which they earned at their last job, called the reservation wage. As the duration of unemployment continues or increases and workers begin running out of unemployment benefits, they will be compelled to accept a lower compensation package. Additionally, employers will find it easier to terminate non-productive employees because they are assured to find five more to do twice the work for half the pay. This theme has already started to show in productivity figures and corporate profits over the last quarters but wages have not yet adjusted as much.
The chart below presents the year-over-year percentage change in output per person and real hourly compensation for workers in the durable goods sector. We see that historically the two metrics have tracked each other while only slightly diverging in a recession. As the increase in real hourly compensation slows or even falls during a recession, companies squeeze more output from the remaining workers. Though this divergence and the theme in general, is certainly not the only one that will drive corporate profits in the coming quarters, I believe it could significantly support companies in the right sectors.
Industries with a large percentage of employees at the extreme end of the wage scale, close to minimum wage, will find it harder to lower their total compensation package any further. Industries with a large percentage of highly-skilled or professional workers may find it harder to lower their compensation packages due to relatively lower unemployment rates. It is the industries with relatively unskilled workers and mid- to lower-middle wages that will most benefit from lowered reservation wages.
The industries, or specific companies, with the most to benefit from this theme are those with employment costs at the lower end of the educational spectrum but revenues from the higher end of the ladder. This is where a little investigation will be needed because sector-level data is not available. Manufacturers of high-end products or those serving business customers may not see their revenues fall as much from continued unemployment. One industry that might benefit is that of industrial machinery manufacturing.
The BLS provides industry-specific occupational employment and wage estimates online and downloadable in Excel. With these, we can get a sense of the workforce characteristics of employees within each industry. More than 85% of the workers within the industrial machinery manufacturing industry earn between $11.00 and $17.50, with 71% working in production occupations. Compare this with another industry, say Wireless Telecommunications where less than 15% of employees make below $17 per hour.
Once an industry is selected, selection of specific companies can be done through standard fundamental analysis. Investors should pay attention to the timing of negotiations for any union labor agreements. Contracts needing to be renegotiated within the next year will give management considerable leverage though wages will still most likely remain higher than non-unionized shops. Caterpillar (CAT) and Deere & Company (DE) are both possible plays within the theme. Trailing price-to-earnings ratio for both are below the industry average at 13.4 and 12.3 times respectively. Further, both companies are benefiting from the boom in agricultural products and strong commodities. Those that would rather play the entire sector for a more diversified bet might look at the Industrial Select SPDR (XLI) or the Materials Select SPDR (XLB). The materials fund holds 30% of the total in metals & mining and 58% in chemical manufacturing. The industrials fund is more diversified across industries with the highest concentration in aerospace & defense with 25% of the total and machinery close behind at 24% of the fund.
The exact reasons for the relatively higher and persistent unemployment in some sectors, though important in putting are country back on track, are only important here in that they will probably continue for some time. The steep decrease in real estate values has hindered mobility in job search for many families and will keep the labor market from correcting as quickly as in previous recessions. Additionally, though manufacturing has rebounded somewhat, construction is a large employer of the low-skilled workforce and has yet to recover. These economic factors, among others, will help to keep labor costs low and should benefit those sectors that can employ at one wage level but earn revenues from groups less affected by the recession
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.