January Employment Update: Expansion 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 with data from the January BLS employment report released earlier this month.

The gain in nonfarm payroll of 304,000 was well ahead of the consensus forecast.

Temp employment was up 1,000, for an annual increase of 2.7%.

The strength in temps continues to provide support to the economic composite's growth outlook.

Given this year’s recovery in the S&P, I moved my assessment of the equity market from undervalued, which I initiated on December 8, to the low end of fair value.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on February 1. The report showed a rise in nonfarm employment of 304,000 in January. The number was well ahead of expectations. Forecasters were looking for a gain of 165,000, according to Bloomberg News. Preliminary numbers for the previous two months were revised upward. For the trailing six months, nonfarm employment has grown on average a robust 232,000 per month.

With the January report, as it does every year, the BLS provided revisions to its establishment data. This year’s revisions were fairly minor, as they usually are. For example, for the rolling 12 months, nonfarm employment grew on average 220,000 per month. The unrevised data produces the same rolling 12-month gain of 220,000.

Temp employment in January grew 1,000 from the previous month and climbed 2.7% year over year. This data series was also subject to annual revision. Here again the changes were relatively minor. For the rolling 12 months, temp employment rose on average a solid 4,700 per month, compared with 8,200 using 2018’s unrevised data. It's an encouraging sign that employers, in the aggregate, are seeing enough strength in their business to hire temps at this pace. As I first noted in early April last year, they appear to be shrugging off concerns about rising tensions over international trade. These concerns, especially at year's end, seemed to have bothered Wall Street more than Main Street.

The January increase in temps was not far off from my estimate of 5,000. I’m leaving my forecasts for the BLS temps data series unchanged through the end of 2019. I continue to look for modest monthly sequential increases in the BLS temps data series and slight annual growth in the American Staffing Association's data through the next four quarters. As a result, the composite continues to signal economic growth for the next 12 to 18 months. The composite is likely to range from 1.5 to 2.0 through the end of the year, 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, March 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 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. The model has been consistently forecasting economic expansion for nearly nine years.

economic forecasting Valuation Composite

My composite of publicly available forward P/E estimates puts the current forward P/E on the S&P of 2,710 (intraday Monday, February 11) at 16.7. I consider this the low end of fair value.

It would seem the opportunity to reap the greatest gains from the latest correction has passed. I first moved to an assessment of undervalued in my December 8 article, when the S&P was 2,655 with a P/E of 15.9, and noted that the S&P could fall lower. I reiterated the undervalued rating about one month later on January 4 when the S&P was 2,516 (P/E of 15.1). The S&P has recovered nearly 8% since then.

I think the current level is still a solid opportunity to deploy long-term capital in U.S. equities. The S&P could retrace some of this year’s recovery if this period of high volatility were to continue. With the economic composite indicating growth, lower levels on the S&P would represent more attractive buying opportunities.

A five-year chart of the valuation composite and the S&P 500 is below. The S&P has recovered about 15% off its December lows. Meanwhile, the P/E composite is still in range of its three-year low.

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.