May Employment Update: Confirms Growth Outlook; S&P Valuation High

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by: Chris Joseph, CFA

Summary

I updated my economic composite with data from the May employment report.

The change in non-farm payroll was slightly below the consensus estimate but still up solidly.

Temp employment was up from April, suggesting employers are bullish on the near-term economic outlook.

This year’s strength in temps continues to provide support to the economic composite's growth outlook.

My valuation model finds the P/E on the broad U.S. stock market remains elevated.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on June 2. The report showed an increase in non-farm employment of 138,000 in May. The figure was slightly under the consensus estimate of a gain of 185,000 as compiled by Bloomberg.

Preliminary numbers were revised down slightly for April (from 211,000 to 174,000) and March (from 79,000 to 50,000). Still, monthly increases in non-farm employment have been averaging a respectable 162,000 through the first five months of this year.

Temp employment in May grew 13,000 from the previous month and climbed 4.9% year over year. The preliminary figures for April and March were little changed. Through the first five months of this year, temps have been growing at a solid average annual rate of 3.9%.

The May temp number was better than my estimate of an increase of 5,000. The outperformance provides more confidence in my estimates for the rest of the year. 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. I expect the composite will range from 2.0 to 4.5 through June 2018, well into positive territory. I do not expect the economy to tip into recession.

The next Labor Department report is scheduled to be released on July 7. I will issue an update to the economic composite shortly after the report comes out.

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.

Valuation Composite

According to my composite of publicly available forward P/E estimates, the current forward P/E on the S&P at the intraday trade of 2,432 (Friday, June 2) is 19.8.

I consider this the high-end of fair value and have concerns the market is vulnerable to a shock at this level.

I would prefer to buy more aggressively at a lower P/E, perhaps around 17.0, which would equate to roughly 2,100 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.

I don't recommend investors completely avoid what appears to be an elevated stock market during periods of economic expansion. In an expansion, companies have the ability to grow into their P/Es by raising their earnings per share. What looks like a rich market P/E today may be more reasonable six to twelve months later as the "E" in "P/E" moves higher.

A five-year chart of the valuation composite and the S&P 500 is below. The S&P has climbed about 7% so far this year, even while the market P/E has remained roughly steady and elevated. This, I believe, is a result of companies, as I mentioned above, growing into their P/Es by improving their earnings.

Track Record

The model's historical record is depicted 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 11% annually.

Methodology

For a full discussion of the Chartwell method, I refer readers to a description of the process in last month's article, under the Methodology heading.

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.