September Employment Report Preview

For many years I have written a regular monthly preview of the Employment
Situation Report.  I have done extensive research on all of the methods
and even visited the stat guys at the BLS to discuss their approach.

My preview gives appropriate respect to the BLS, but also to the leading alternative methods. Why is this so important?  I have created a little story which may be helpful on this front.

A Helpful Bit of Fiction

Suppose we have a contest to guess the number of coffee beans in a jar.  Here is a picture of such a contest in Bluffton, Ohio, just down the road from where I grew up.  Let us take some liberties with the contest rules.  The contest is done every week.  Every contestant gets to know how many beans were in the jar the week before, but the shop is withdrawing and adding beans each day.

2471-icon-and-common-grounds-invites-you-enter-count-coffee-bean-contestLet's consider four different approaches for determining the number of beans.

  1. 1)  Lift the jar to estimate the weight.  Compare the weight with what you think it was last month and adjust your guess.
  1. 2)  Track the amount of coffee served during the week.  Estimate how many beans must be added to replenish the supply.

3)  Count the scoops of beans added.  Use a sampling procedure to estimate the number of beans in a scoop.

 

4)  Measure the jar.  Determine its volume.  Determine the volume of a bean.  Do the math, sort of like this contestant in a similar contest.

 CalculationsThere is an actual count of the beans, but that report is available only after five days.  (Fast counters are in short supply!)  The contestants want to have a winner declared each week at the barn dance.  To meet this demand, the contest administrators decide to pick one contestant approach and declare that to be the "official" result.  Since the math contestant has a good long-term record, that is the one chosen.

A few days later the actual count is known.  By then no one cares, since the prize has already been awarded.

And that is what we all do each month in trying to squeeze meaning from the employment situation report.  Even though the BLS is just a competing contestant (readers are invited to unmask the others) their estimate is anointed as official.

Background

We rely too much on the monthly employment report.  It is a
natural mistake.  We all want to know whether the economy is improving
and, if so, by how much. Employment is the key metric since it is
fundamental for consumption, corporate profits, tax revenues,
deficit reduction, and financial markets.  Whenever there is an important question, we all seize on any available information.  While we might know the limitations of the data, any concern is briefly acknowledged — if at all — and then swiftly put aside.

The Data

We would like to know the net addition of jobs in the month of September.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

  1. An initial report of a survey of establishments.
    Even if the survey sample was perfect (and we all know that it
    is not) and the response rate was 100% (which it is not) the
    sampling error alone for a 90% confidence interval is +/- 100K
    jobs.
  2. The report is revised to reflect additional responses over the next two months.
  3. There is an adjustment to account for job creation — much maligned and misunderstood by nearly everyone.
  4. The final data are benchmarked against the state employment data
    every year. This usually shows that the overall process was very
    good, but it led to major downward adjustments at the time of the
    recession. More recently, the BLS estimates have been too low, as revealed in the just-released report.  For the year ending in March, 2012, the BLS estimate was off by about 30K jobs per month overall, and 35k jobs per month on private employment.

Competing Estimates

The BLS report is really an initial estimate, not the ultimate
answer.  The BLS is actually like one of the contestants, with the full report coming later.  The market uses this estimate as "official" and declares winners and losers on that basis.  No one pays any attention to the final data, which we do not see for eight months or so.

  • ADP has actual, real-time data from firms
    that use their services. The firms are not completely
    representative of the entire universe, but it is a different and
    interesting source. ADP reports gains
    of 162K private jobs on a seasonally adjusted basis.  In general, the
    ADP results correlate well with the final data from the BLS, but not
    always the initial estimate.  It is an independent measure that deserves
    respect.  The revisions noted above moved the BLS closer to the ADP conclusions over the time period cited.
  • TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth. TrimTabs forecasts gains of about 210,000.  TrimTabs thinks that the BLS is wrong.  They write as follows:

"(The BLS) is missing the current acceleration in job growth.  In August, the BLS
reported job growth of only 96,000 new jobs, nearly half of the job
growth TrimTabs reported.  TrimTabs reports that the BLS survey
typically captures employment growth more effectively in government and
large corporations while nearly 84% of the recent employment growth is
occurring in small and medium sized businesses."

  • Economic correlations. Most Wall Street
    economists use a method that employs data from various inputs,
    sometimes including ADP (which I think is cheating — you should
    make an independent estimate).
    • Jeff Method.  I use the four-week moving average of initial
      claims, the ISM manufacturing index, and the University of
      Michigan sentiment index. I do this to embrace both job creation
      (running at over 2.3 million jobs per month) and job destruction
      (running at about 2.1 million jobs per month). In mid-2011 the
      sentiment index started reflecting gas prices and the debt ceiling
      debate rather than broader concerns. When you know there is a
      problem with an input variable, you need to review the model. For
      the moment, the Jeff model is on the sidelines.  The recent uptick in consumer confidence, despite gas prices, the fiscal cliff, and Europe, is encouraging for jobs.  It remains difficult to account for the effect of
      headlines about Europe and the fiscal cliff.  The model inputs are
      improving a bit, but I do not think we have a good grasp on job
      creation.
    • Street estimates generally follow my method, but few reveal much
      about the specific approach.  These estimates usually adjust for the ADP report, but there was little reaction to the strong estimate for this week.  Everyone cites the "poor" ADP record in matching the BLS.
  • Briefing.com cites the consensus estimate
    as 120K, while their own forecast is for 165K.  Their private jobs
    forecasts are about 10K higher, since the loss of public jobs is
    well known.
  • Gallup sees unemployment as stable  at 8.1% on a seasonally adjusted basis in mid-September, the time of the BLS
    data collection.  This is interesting since they have a different
    survey from the government, a relatively new approach to seasonal
    adjustment, and an extremely bearish and political approach in past
    commentaries.  Gallup's methods deserve respect, so I am watching
    closely.

Failures of Understanding

There is a list of repeated monthly mistakes by the assembled jobs punditry:

  • Focus on net job creation.  This is the
    most important.  The big story is the teeming stew of job gains and
    losses.  It is never mentioned on employment Friday.  The US economy
    creates over 7 million jobs every quarter.
  • Failure to recognize sampling error.  The
    payroll number has a confidence interval of +/- 105K jobs.  The
    household survey is +/- 450K jobs.  We take small deviations from
    expectations too seriously — far too seriously.
  • False emphasis on "the internals." 
    Pundits pontificate on various sub-categories of the report, assuming
    laser-like accuracy.  In fact, the sampling error (not to mention
    revisions and non-sampling error) in these categories is huge.
  • Negative spin on the BLS methods.  There
    is a routine monthly question about how many payroll jobs were added
    by the BLS birth/death adjustment.  This is a propaganda war that
    seems to have ended years ago with a huge bearish spin.  For anyone
    who really wants to know, the BLS methods have been under-estimating
    new job creation.  This was demonstrated in the latest benchmark
    revisions, which added more jobs.

It would be a refreshing change if your top news sources featured any of these ideas, but don't hold your breath!

And most importantly, it would be helpful if anyone would realize that the BLS is just one estimate.  The bean counter example illustrates this.

Trading Implications

The rules are changing for trading the employment report.  You can still expect the aggressive bearish spinfest that usually provides a "dip to cover," but things are a bit different now.

With the Fed intentions declared, we have left the environment where good news might be bad and bad news might be good — all because the Fed might be more aggressive.

My operating expectation is that good news is now good.  It will not stimulate the Fed to tighten.  Bad news is bad, but if it is bad enough, the Fed might add to the QE3 quantities.

I understand that most traders and pundits are in denial about this (as I explained here), but that just provides a better opportunity for the rest of us.

The sophisticated investor does not complain about government policy.  He includes likely outcomes as part of his investment plan.