January Staffing Levels Signal Growth Outlook; S&P Valuations Remain Rich

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by: Chris Joseph, CFA

Summary

I updated my economic composite to include data from the January employment report.

After a pause in December, the number of temp workers increased again sequentially in January, suggesting employers are bullish on the near-term economic outlook.

Year over year, temps continued to climb, providing support to the economic composite.

My valuation model finds the broad U.S. stock market remains richly valued.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on February 3. The report showed an increase in nonfarm employment of 227,000 in January. The preliminary numbers for December and November were raised slightly higher.

Of the data series included in the monthly Labor Department report, the most vital to my economic composite is the category of temporary help services. Temp employment in January increased 15,000 from the previous month and grew 3.3% year over year. The preliminary numbers for December and November were essentially unchanged. Temps were down 13,000 sequentially in December and up 20,000 in November.

January's sequential growth marks a reversal from the sequential decline in December and represents an encouraging sign. I wasn't much discouraged by December's report, because, as I mentioned at the time, one down month for temps is not necessarily the start of a trend, and sequentially down months occur fairly frequently during expansions.

As it does at this time every year, the Bureau of Labor Statistics revised the establishment survey data as a result of its annual benchmarking process and updating of seasonal adjustment factors. Seasonally adjusted data from January 2012 forward are subject to revision. It's my practice to restate only the previous 12 months of data to strike a balance between maintaining the historical integrity of the model - after all, the model's outputs are based on data available at that time - and being sensitive to using the most accurate data in the model going forward.

While November and December's preliminary numbers were essentially unchanged, most of the earlier months of 2016 were revised slightly downward. None of the revisions were enough to push the model into negative territory. With lower numbers in '16, there are easier monthly comparisons through most of the rest of this year. This ought to keep the economic composite positive, indicating expansion for 2017.

I feel comfortable with my monthly estimates for temp employment and thus have little change to the economic composite. I continue to forecast modest monthly increases in the BLS temps data series for the economic composite. As a result, the composite continues to signal economic growth for the next 12 to 18 months. Aided by easy comparisons in the temp staffing data series, I expect the composite will range from 2.0 to 4.0 this year. I do not expect the economy to tip into recession.

Figure 1 below shows the actual monthly values of the economic composite from 1991 through the present and the estimated values through early 2019. In general, the composite remains positive during periods of economic expansion and turns negative during periods of recession. The vertical dashed lines mark the inflection points when the economy is poised to enter recession or has safely exited recession. It typically takes three consecutive months of a change in sign (from positive to negative and vice versa) to confirm a change in outlook.

Figure 1. Chartwell Economic Composite

Shaded areas indicate recession; Vertical dashed lines indicate inflection points

Valuation Composite

According to my composite of publicly available forward PE estimates, the current forward PE on the S&P at Friday's close (February 3) of 2,297 is 19.5.

The nearly 10% increase in the S&P since early November has pushed the market PE to levels last seen in late April 2015. I consider this the high end of fair value and have concerns that the market is vulnerable to a shock at these levels.

I would prefer to buy more aggressively at a lower PE, perhaps around 17.0, which would equate to roughly 2,000 on the S&P. However, I would continue to make regularly planned dollar-cost averaging allocations to equities that investors intend to hold for the long term, such as monthly or bi-weekly contributions to a 401(k) plan.

A five-year chart of the valuation composite and the S&P 500 is below. The recent spikes in the S&P 500 and the valuation composite are rather dramatic.

Figure 2. Chartwell Valuation Composite vs. S&P 500

Weekly data

Methodology

The Chartwell method uses a two-staged approach to determining the attractiveness of the U.S. stock market. The method is outlined in the flowchart below.

Figure 3. Chartwell Process

In the first stage, the economic composite gauges the strength of the U.S. economy. A forecast of positive readings indicates economic growth, while a forecast of negative readings implies a period of recession. My methodology suggests overweighting equities in the former scenario and underweighting in the latter.

The Chartwell economic composite of leading indicators is based primarily on employment data from government and private sources. It relies on the assumption that employers, in the aggregate, are rational economic actors, hiring and firing workers to meet current and prospective levels of demand for their goods and services. Some categories of employment are better leading indicators of the health of the economy than others. My research has identified those categories and weighted them accordingly in the composite. The final piece of the composite is a factor for the shape of the yield curve. Yield curve inversion has a long track record of successfully identifying the onset of recessions.

When the economic composite is signaling a recession, equities are unattractive and should be underweighted. In this case, the valuation reading is immaterial. This is primarily because Wall Street analysts tend to widely overestimate earnings preceding and during recessions. As a result, the market PE looks lower than it actually is.

In the second stage, the valuation composite measures the relative attractiveness of U.S. equities. The valuation metric is a composite of publicly available forward PEs on the S&P 500. When the composite indicates the market is low or fairly valued, equities should be bought. When the composite is high, it's a signal to hold.

The historical record can be seen in the chart below. The economic composite predicted the beginning and end of the 2000 recession and the 2008 recession. It also predicted the end of the early 1990s recession. Some of the data series used in the composite did not exist before 1990; hence, the start of the track record at that time.

In the two historical Overweight periods, the S&P rose 13% and 14% on an annualized basis. In the two historical Underweight periods, the S&P fell 18% and 9% on an annualized basis. In the current Overweight period, the S&P has been returning 10% annually.

Figure 4. Chartwell Economic Composite vs. S&P 500

Shaded areas indicate recessions; Vertical lines indicate inflection points

As the economist Paul Samuelson once said, "The market has predicted nine of the last five recessions." These "extra" recession predictions are excellent buying opportunities, if they can be identified.

Fortunately, the model is very good at identifying market declines that are followed not by recessions but by rebounds. The model identified as buying opportunities (1) the euro crisis of summer 2010, (2) the U.S. debt crisis of fall 2011, (3) the budget sequester concerns of fall 2012, and (4) the drop in commodity prices that led to recession fears in late summer 2015. These were all difficult periods in which to buy equities, especially the first three, because there was a strong consensus for a pending "double-dip" recession so soon after the global financial crisis of 2008. Followers of the model, on the other hand, could invest with confidence because the economic composite was signaling little chance of a recession within 12 months during those times.

The average annual return on the S&P 500 in the historical Overweight periods are 13% and 14% and 10% so far in the current Overweight period. These returns can be enhanced by taking advantage of the market declines that occur while the economic composite remains strong. Readers can expect articles alerting them to buying opportunities when the market becomes out of synch with the economic composite.

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.