October Employment Update: Growth Outlook Intact; S&P Low End Of Fair Value

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Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Chris Joseph, CFA
Summary

I updated my economic composite following the release of the October employment numbers on Friday, Nov. 5.

The gain in nonfarm payroll of 250,000 surpassed the consensus forecast of 200,000.

Temp employment was up 3,000, for an annual increase of 2.2%.

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

The current market decline has pushed the P/E composite to its lowest level in nearly three years, creating an attractive buying opportunity.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on Nov. 2. The report showed a rise in nonfarm employment of 250,000 in October. The number was ahead of expectations. Forecasters were looking for a gain of 200,000, according to Bloomberg News. The BLS reported that Hurricane Michael had “no discernible effect” on its data.

Preliminary numbers for the previous two months were essentially unchanged. For the trailing six months, nonfarm employment has grown on average a robust 216,000 per month.

Temp employment in October was up 3,000 from the previous month and increased 2.2% year over year. Preliminary figures were revised slightly downward.

For the last six months, temp employment has risen on average a solid 4,000 per month, for an average increase of 2.8%. It's an encouraging sign that employers are seeing enough strength in their business to hire temps at this pace. As I first noted in early April, they appear to be shrugging off concerns about rising tensions over international trade.

The October increase in temps was in line with my forecast. As a result, I’m leaving my forecasts for the BLS temps data series unchanged through the end of the year and into 2019. I continue to look for modest monthly sequential increases in the BLS temps data series. With this forecast, the composite continues to signal economic growth for the next 12 to 18 months. The composite is likely to range from 1.5 to 2.5 through the middle of next year, well into positive territory. I do not expect the economy to tip into recession, despite the fears the market decline may be signaling.

The next Employment Situation report is scheduled to be released on Friday, Dec. 7. 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 the middle of 2020. 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.

economic forecasting Valuation Composite

My composite of publicly available forward P/E estimates puts the current forward P/E on the S&P at Friday’s close (Nov. 5) of 2,723 at 16.7. The P/E composite hasn't been this low since early 2016, a period of market correction that turned out to be short-lived. At that time, the economic composite was also signaling growth in the 12 to 18 months ahead. I consider this the low end of fair value.

On Oct. 5, when the S&P was 2886, I suggested 2765 as an attractive buying point. So I think the current level is a solid opportunity to deploy long-term capital in U.S. equities. Of course, the S&P could fall further if this period of high volatility were to continue. But with the economic composite indicating growth, lower levels on the S&P would represent more attractive buying opportunities.

The current climate of rising earnings estimates supports a solid outlook for stock prices. S&P earnings continue to come in strong. According to FactSet, with 74% of the companies in the S&P 500 having reported third-quarter earnings so far, 78% of those companies have posted a positive earnings surprise. Earnings beats tend to cause analysts to raise their forward earnings estimates, which lowers forward P/Es.

A five-year chart of the valuation composite and the S&P 500 is below. October’s market correction was sharp and steep, sending the P/E composite down about 7%. The composite is about 20% off this year’s high of 20.6.

equity market valuation 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 10% annually.

equity allocation Methodology

For a full discussion of the Chartwell method, I refer readers to a description of the process in my April, 2017, 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.