June Employment Update: Growth Forecast On Track; S&P Valuations Rich

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by: Chris Joseph, CFA
Summary

I updated my economic composite following the release of the June employment report.

The rise in nonfarm payroll was strongly ahead of the consensus estimate.

Temp employment was up from May, 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 remainselevated.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on July 7. The report showed an increase in nonfarm employment of 222,000 in June. The figure was solidly ahead of the consensus estimate of a gain of 170,000 as reported by Bloomberg.

On another positive note, preliminary numbers were revised upward for the previous two months. May’s gain of 138,000 jobs was revised to 152,000, and April’s gain was increased from 174,000 to 207,000. Monthly increases in nonfarm employment have been averaging a solid 180,000 through the first half this year.

Temp employment in June grew 13,000 from the previous month and climbed 4.7% year over year. The preliminary figures for May and April were essentially unchanged. Since the start of the year, the monthly gain in temp employment has averaged a healthy 4%. It's an encouraging sign that employers, in the aggregate, are seeing enough strength in their business to want to bring on temps at this pace.

The June 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 1.5 to 3.5 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 Friday, August 4. I expect to provide 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 2,418 (Friday, July 7) is 19.6.

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 my April employment update, under the heading “Methodology.”

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.