October Employment Update: Growth Outlook Intact; S&P Fairly Valued

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by: Chris Joseph, CFA
Summary

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

The gain in nonfarm payroll was short of consensus but still up a strong 261,000.

Temp employment was up solidly month to month and up 4.1% year over year.

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

The trend of rising earnings continues to argue for fair value on the S&P.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on November 3. The report showed a rise in nonfarm employment of 261,000 in October. Forecasters were looking for a gain of 325,000 as reported by Bloomberg.

Preliminary numbers for the previous two months were raised meaningfully. In fact, the September decline of 33,000 – attributed to the effects of two major hurricanes – was revised to a gain of 18,000. Increases in nonfarm employment have been averaging a robust 169,000 per month through this year.

Temp employment in October increased 18,000 (+0.6%) from the previous month and climbed 4.1% year over year. The preliminary figures for August and September were adjusted upward slightly.

Since the start of the year, the year-over-year gain in temp employment has averaged a solid 4% each month. It's an encouraging sign that employers, in the aggregate, are seeing enough strength in their business to bring on temps at this pace.

The October gain in temps was ahead of my estimate, providing more confidence in my current outlook. I continue to forecast modest monthly sequential increases in the BLS temps data series, equating to low single-digit annual growth rates. As a result, the composite continues to signal economic growth for the next 12 to 18 months. The composite is likely to range from 2.0 to 3.0 through the end of 2018, well into positive territory. I do not expect the economy to tip into recession.

The next Employment Situation report is scheduled to be released on Friday, December 8. 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 nearly the end of 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

My composite of publicly available forward P/E estimates puts the current forward P/E on the S&P at the intraday trade of 2,580 (Friday, November 3) at 19.8.

The S&P has climbed 5% in the two months since I made the change from “high end of fair value” to “fairly valued” on August 30, in my article on the second-quarter staffing data from the American Staffing Association.

Normally, I’d call this level the high end of fair value. But it’s my sense that one of the components of my composite P/E, an input I’ve been tracking for well over a decade, is about to advance its four-quarter earnings estimate by one quarter. Given the robust outlook for forward earnings, this adjustment could add as much as 2% to 3% to the denominator of the P/E. In rough numbers, that would bring the current composite P/E of 19.8 closer to 19.0 than 20.0.

S&P earnings continue to come in strong. As FactSet noted in its most recent “Earnings Insight” report dated October 27, with 55% of the companies in the S&P 500 reporting results for 3Q17, 76% of those companies beat the mean EPS estimate. Earnings beats tend to cause analysts to raise their forward earnings estimates, which pushes down forward P/Es.

Still, I prefer to be a more aggressive buyer at a lower P/E, perhaps around 17.0, which would equate to roughly 2,200 on the S&P. For now, I would still 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 valuation composite took a clear trend down in the month of August and has reversed itself through the market climb of September and October.

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.