Employment Is Procyclical

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by: Scout Finance

Jobless claims are at record lows.

At the same time structural unemployment is also very high.

If corporate profits and the labor market both show declines the economy may go into a recession.

I believe a lot of what most people understand economics is backwards. Anyone who comes to understand macro goes through a period of thinking certain mistruths about indicators because it is what is spouted out by Fed governors and losing money managers. It may be obvious that the Fed gets its predictions wrong, but it may be confusing to understand how money managers who have actually beaten the market over the time frame of the latest bull market don't understand macro. The reality is a lot of these managers simply bought high beta stocks like the FANG and rode them higher. They are still riding them, but it doesn't mean this game will last forever. Should Bill Ackman be considered a great investor because he outperformed the market for several years? Outperforming the market for several years becomes meaningless if you lose it all in a short period of time. The money managers who own stocks like Netflix (NASDAQ:NFLX) look the smartest right before the crash.

The data point which is misconstrued the most is employment data. Employment is a lagging indicator. This means low jobless claims is bad news for the economy after it has been low for a sustained period of time. Economic growth doesn't come from new jobs being added to the economy. Economic growth comes from productivity growth and new technologies. If the labor market is too tight, corporate profit margins peak. Long-term it is important to have a high number of people employed, but on a cyclical basis, high jobless claims signal a coming recession.

There are a few reasons why employment is touted as an important indicator for a strong economy. The first is politicians and the Fed want to tout their own policies as excellent. The Fed doesn't have to be political to have a big ego. How often do you hear anyone describe how bad their decisions were? If Yellen was objective and said QE has been bad policy, the natural question would be "why don't you resign then?" When investors hear this repetition about how great low employment is they repeat the misinformation and allocate capital accordingly. Finally, the average person probably doesn't understand how a recession can be considered healthy for the long-term economy because he/she just lost his/her job. The media wants to get listeners, so they don't want to start telling people what they don't want to hear even if it's the truth.

Using data to explain this point, the long-term employment situation is actually quite terrible. The chart below shows that 23% of workers in their prime employment age are not working. This is an obvious problem, which signifies a structural problem with the labor market. This may be caused by a skills gap as workers aren't qualified for the jobs employers have to fill.

The cyclical side of employment looks great. It's actually too great as this level of initial jobless claims as a percentage of the labor forces is at record lows. This is unsustainable because the labor market is cyclical. When jobless claims are too low it causes wages to increase which causes profits to fall, which then causes jobless claims to skyrocket.

Part of the political discussion has been about income inequality, but I would argue Fed policy has exacerbated this problem as low interest rates help stock owners and hurt savers. As you can see below, profit margins have already peaked. The last time profit margins started declining was 2006 right before the recession. It be reasonable to assume a recession is coming within 6 months if profit margins continue to fall.

Profit margins and jobless claims signal a possible recession in 2016. The Fed is raising rates into a recession because it doesn't understand what point the economy is in the credit cycle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.