Friday, 1 June 2012

May Employment Preview

We rely too much on the monthly employment outlook 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.
Since the subject is so important, most people place too much emphasis on the official results, losing sight of the important elements of context.  I will first summarize the BLS official methodology.  Next I will review alternative approaches and those forecasts.  I will conclude with some ideas about what to watch for.
The Data
We would like to know the net addition of jobs in the month of May.
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. (Seehere for a more detailed account of this, along with supporting data).
Competing Estimates
The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.
  • 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 only 133K private jobs. Steven Hansen at Global Economic Intersection endorses the ADP method over the BLS result. He has astrong analysis covering many nuances in the data. For those who really want to understand the jobs story, it is well worth reading.
  • 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 124,000. They have been pretty bearish on job growth, but their approach is worth serious consideration.
  • 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). 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.  This month would be impossible for my model anyway, since the ISM data will not be released until after the employment report.
  • cites the consensus estimate as 150K and their own forecast is for 175K.
  • Whisper numbers were reported to be revised lower today after the ADP report, with some predicting only a gain of 75,000 jobs.  Art Cashin reported that traders believe there is a 20% chance that the report will show fewer than 100,000 jobs gained.  If traders understood sampling error, they would realize that this statement would be true even if the actual job gain was 150,000.
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, as well as the most recent report from state employment offices.
Trading Implications
My experience with employment Fridays is that there is little benefit to being aggressively long before the report.  The spinfest usually provides shorts with a morning "dip to cover" when the number is surprisingly good.
The recent pattern has been a weaker-than-expected initial report, followed by upward revisions.  Check out last month's preview, where I covered this in more detail, including some great analysis from Scott Murray.
Adding to tomorrow's volatility we will have the ISM manufacturing report as well as data on personal income and spending.

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