Today was one of almost non-stop speculation about Friday’s employment report and how the Fed will react to it. ADP had a predicion of job growth under 100K while the consensus is for 140K. Most of those interviewed on CNBC were talking about differences in Fed policy based upon 50K changes in the result.
Readers of "A Dash" can get an insight into how the Fed is likely to respond. I tried to do this last month with a description of methodology and an example of the error rate. Sometimes it takes a graphic analogy, well outside of the problem area, to make the point. I shall try again.
As you read this, you should be aware that the Fed Governors and their excellent staff understand what I am explaining. They get it perfectly. Unlike most on the Street, I am not speaking to them, trying to tell them their job. I am trying to help the rest of us understand what they already know.
Let us suppose that we are in a bar that has a dartboard, a tried and true Wall Street analogy. Next let us suppose that we set the throw line fifteen feet from the dart board. The bullseye represents "truth" as we call it in statistics classes. It exists, but it can only be estimated. In this case it is the actual payroll growth for the month. A player (perhaps having consumed a few brewski’s) steps to the line and throws at the board. We mark the location of the first dart. That is the first payroll jobs estimate, based upon only partial returns from a survey.
Now we let the player step up a few feet to a twelve-foot line. The player throws again, and we mark the location of the second dart. This is based upon the first revision of the payroll survey results.
Finally, we let the player throw from a regulation distance of about eight feet from the board. The result is the payroll number after both revisions, about 90% of those originally asked to respond.
Here is the key point:
We now go to the board and draw a new bullseye around the position of the first (and least accurate) dart. We accept that as "truth."
Briefly put, it is quite possible that ADP, or Briefing.com, or Ed Yardeni, or some other economist made an accurate prediction of truth, because we actually score the game based upon where the first, and least accurate, dart lands.
Even the final dart has an error band of over 400K jobs at the 90% confidence level.
Most employment numbers, probably the vast majority, are off by more than 50K jobs even after the final revision. Despite this, the Street will swing billions of dollars on this result.
The main point is that the Fed does not do this. They understand the nature of the estimate. They look at three-month groupings and trends, where the error is reduced.
I’ll pursue this further with how an investor can make use of this information, but it is important to keep in mind when viewing Friday’s report — and the revisions for prior months. Also please note that the revisions change the base for the current month — often forgotten.