Here's A Canary That You Have Not Seen Before

|
Includes: DIA, IWM, QQQ, SPY
by: Lawrence Fuller

Summary

The consensus view is that the US labor market is strong.

The rising number of negative revisions to the initial estimate of the number of jobs created each month indicates otherwise.

The pattern in the revision data is reminiscent of 2007, just before the last recession.

I am always looking for new data that will help me better understand what is happening in our economy today. I do so in hopes of improving the accuracy of my market outlook and the performance of my portfolio strategy that is derived from that outlook. Sometimes I simply look at old data in new ways to see if it will provide me with insight. To that end, I came across a pattern in the monthly payroll data at the beginning of this year that I found to be particularly clairvoyant. After tracking the incoming data each month and monitoring this pattern, I am even more convinced of its predictive prowess. I think it is a canary in the economic coal mine that I have not seen anyone else discuss before.

The consensus view is that the US labor market is strong and strengthening. This is one reason that the Federal Reserve is considering a second interest rate increase at its June meeting. It is also the primary reason why most economists on Wall Street are forecasting a strengthening economy in the second half of this year.

Contrary to the consensus view, I asserted in January of this year that the labor market was beginning to weaken. What brought me to this conclusion were the revisions being made each month by the Bureau of Labor Statistics to its previous two monthly estimates, as is customary with every new jobs report. More specifically, I focused on the number of downward revisions and the size of those revisions between the initial estimate and the second and final revision to that estimate. I created the table below using data available on the Bureau of Labor Statistics website at that time to show the pattern which I believe identifies a weakening labor market and economy. I referred to it as our "revision index."

Revision Index

Mean revision

Negative months

S&P 500 Total Return

2015

-10,000

6

1.40%

2014

37,000

1

13.69%

2013

21,000

4

32.39%

2012

24,000

3

16.00%

2011

28,000

3

2.11%

2010

40,000

1

15.06%

2009

12,000

4

26.46%

2008

-73,000

11

-37%

2007

5,000

6

5.49%

2006

23,000

5

15.79%

2005

31,000

3

4.91%

2004

21,000

4

10.88%

Before explaining how this index was constructed, providing the updated version, and sharing what I think it indicates, let me provide some background on what is considered to be the most important economic indicator of health that we have each month-the jobs report.

The jobs report provides us with insight into what is happening in the economy right now. For this reason it is considered a timely coincident indicator of economic activity. We learn about the number of jobs created, the quality of the jobs and how many were part-time, as well as information pertaining to average hourly earnings and the length of the workweek. These are all valuable data points that receive extensive coverage and analysis by pundits and the press. What receives virtually no coverage at all are the revisions to the estimates for the prior two months. It is in these revisions that we find the canary.

In the most recent jobs report, the BLS estimated that 160,000 jobs were created in April. As always, the estimates for the previous two months were revised with more incoming data. The gain in March's initial estimate of 215,000 was revised lower to a gain of 208,000. That number will be revised a second and final time in next month's report. February's initial estimate of 242,000, which was first revised upward to 245,000, was finally revised lower 233,000. These numbers, on a stand-alone basis, still indicate a strong economy.

The BLS acknowledges that its initial estimate is subject to significant revisions, and the margin for error can be as great as 100,000 jobs per month. The BLS estimate is a survey that is subject to sampling errors, which is why it makes seasonal adjustments. It also makes adjustments to the jobs numbers in order to account for job creation it assumes is resulting from the formation of new businesses that are too new to be included in its survey results. The statistical model it uses for this calculation is called the birth/death model.

The problem with this model is that it misses major turning points in economic activity. It overstates job creation by new businesses as the economy is slowing significantly, or contracting, because fewer new businesses are actually being created. It also understates job creation when the economy is on the cusp of a new expansion and lots of new businesses and jobs are being created as a result. This is where we find the canary.

I provide an updated chart below that shows the mean revision to the initial job estimate for the 12 months of each calendar year, as well as the number of monthly revisions that were negative. Both are relevant. The data is updated through February of this year, which is the last month for which we have had a second and final revision to the initial job estimate.

Revision Index

Mean revision

Negative months

S&P 500 Total Return

2016

4,000

1

1.30% YTD

2015

-4,000

7

1.40%

2014

37,000

1

13.69%

2013

21,000

4

32.39%

2012

24,000

3

16.00%

2011

28,000

3

2.11%

2010

40,000

1

15.06%

2009

12,000

4

26.46%

2008

-73,000

11

-37%

2007

5,000

6

5.49%

2006

23,000

5

15.79%

2005

31,000

3

4.91%

2004

21,000

4

10.88%

Notice that in the years prior to the last recession the BLS had a tendency to under-report job creation as the economy was expanding. In 2005 there were only three downward revisions (and nine upward) between the initial estimate and the final revision two months later. The mean, or average, revision during that year was an increase of 31,000 jobs per month. As the rate of economic growth slowed in 2007, the number of negative revisions increased to six and the size of the upward revision on average began to decline. When the recession began in 2008 nearly every month was a downward revision and the average revision was a decline of 73,000 jobs per month.

In 2010 a new economic expansion was underway. The BLS significantly underestimated job growth as that expansion began. The upward revisions in 2010 occurred in every month but one, and the average upward revision was 40,000 jobs. In hindsight, an in increase in the number of negative monthly revisions and the decrease in the average size of those upward revisions in 2007 was a warning sign. The economy was slowing significantly.

Now take a look at the data compiled for 2015. The number of negative monthly revisions rose to seven, which is the highest number we have seen during this expansion, and the average monthly revision was a loss of 4,000 per month. This is eerily similar to 2007. With only two months of data for 2016, we have already seen one downward revision and the first revision to the March job number was also downward.

I continue to believe the US economy is at another turning point similar to what we saw in 2007. Whether that turning point means another recession or a significant slowdown in the rate of economic growth is still to be determined. The historical pattern in this data is one of the reasons that my estimate for US economic growth in 2016 is a paltry 1%. It is also a contributing factor to my forecast that S&P 500 corporate earnings will fall significantly short of current estimates and that the S&P 500 will suffer a bear market decline before the year is over. Should the Federal Reserve continue to increase interest rates, as it has intimated, then that will only strengthen the resolve in my outlook.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.