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

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by: Chris Joseph, CFA
Summary

I updated my economic composite with data from the March BLS employment report released on Friday, April 5.

The gain in nonfarm payroll of 196,000 beat the consensus forecast of 175,000.

On a month-to-month basis, the number of temp workers fell 5,000. However, temps continued to rise year over year, providing support to the economic composite’s growth outlook.

In light of this year’s continued recovery in the S&P, I moved my assessment from low end of fair value to fair value.

Economic Composite

I updated my economic composite to reflect the release of the U.S. Labor Department's employment report on April 5. The report showed a rise in nonfarm employment of 196,000 in March. The number was ahead of expectations of a gain of 175,000. Preliminary numbers for the previous two months were revised slightly upward. This marked considerable improvement from the February report, when payrolls grew just 20,000.

Temp employment in March fell 5,000 from the previous month but rose 1.5% year over year. Preliminary figures for the previous two months were revised downward. Monthly comparisons have been weak this year. As a result, temp employment has been flat in the past six months. Still, year-over-year growth rates are fairly solid, averaging an increase of 1.8% in the last six months.

The trend is a little concerning. If the monthly change remains flat to down, it will eventually cause the year-over-year comparisons to turn negative. For now, I’m modeling very modest monthly gains in temp employment through the rest of the year.

Meanwhile, the temp employment number for the fourth quarter of 2018 from the American Staffing Association, which was released in mid-March, was strong. The ASA’s quarterly data, another one of the inputs of the economic composite, showed a sequential increase of 180,000 in the average number of temp workers employed per week in the quarter, for an annual increase of 2%. I was looking for a gain of just 50,000 and an annual decline of 2%. The outperformance pushed up my estimates through the rest of the year, helping to keep the composite above zero.

The flattening yield curve is also a source of concern. The composite includes a numerical “reward” for a positively sloping curve and a “penalty” for an inverted curve. So far this year, the differences in the monthly averages I use for the 3-month and 10-year Treasury rates have reflected a normal curve. But after falling to a difference of just 12 basis points in March, the potential for inversion is a concern.

Using fairly conservative increases in temp workers as estimates and a positive outlook for the yield curve, the economic composite continues to remain above zero through the end of the year, although it gets as low as 0.5 in the fourth quarter. It takes three months of a score below zero to signal recession - that doesn’t seem likely at this point. The composite has flirted with the x-axis as recently as mid-2016, and the economy continued to grow. Finally, growth in temps will come up against some easy comparisons in the first quarter of 2020, which ought to push the composite up over 1.0 again.

The next Employment Situation report is scheduled to be released on Friday, May 3. 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 of 2,887 (intraday April 8) at 17.4. I consider this fair value. This represents a change from my March 11 report, when my assessment stood at the low end of fair value. Since then, the S&P has added 5% and the composite has increased from 16.7.

I prefer to be a more aggressive buyer at a lower P/E, perhaps closer to 16.0, which would equate to roughly 2,700 on the S&P. For now, 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.

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 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. 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.

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.