February Employment Update: Expansion On Track; S&P At Low End Of Fair Value

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by: Chris Joseph, CFA
Summary

I updated my economic composite with data from the February BLS employment report released on March 8.

The gain in nonfarm payroll of 20,000 was well short of the consensus. Despite the miss, the increase was in line with an expanding economy.

Temp employment was up solidly for an annual increase of 2.2%.

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

The P/E composite suggests the S&P is at 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 March 8. The report showed a rise in nonfarm employment of just 20,000 in February. The number was a disappointment against expectations of a gain of 180,000. Preliminary numbers for the previous two months were revised slightly upward. Despite January's weak gain, for the trailing six months, nonfarm employment has grown on average a strong 190,000 per month.

I'm not concerned about the nonfarm miss for a few reasons. First, it's very difficult to estimate one single month of payroll gains because of the variability in the data stream. Second, a single month of modest growth in an expanding economy is not unusual. Finally, the trend in temporary help services was positive.

Temp employment in February grew 6,000 from the previous month and climbed 2.2% year over year. Adjustments to preliminary figures for December and January were mixed, with an upward revision for December and a downward one for January.

For the last six months, temp employment has risen on average a solid 6,000 per month for an average increase of 2.0%. 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 last year, they appear to be shrugging off concerns about international trade tensions.

The February increase in temps was in line with 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 ASA series 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, April 5. 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 (March 8) of 2,743 at 16.7. I consider this the low end of fair value.

It appears 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 9% 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. While the S&P has come off the December lows, the P/E composite still remains below its range of the last four years.

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 respectively. In the two historical Underweight periods, the S&P fell 18% and 9% on an annualized basis respectively. 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.