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 (preliminary) report, which is really only an estimate. In about eight months, we’ll have an accurate count from state employment offices, but by then no one will care.
There are several competing methods that provide independent approaches to analyzing employment.
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:
- 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.
- The report is revised to reflect additional responses over the next two months.
- There is an adjustment to account for job creation — much maligned and misunderstood by nearly everyone.
- 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. (See here 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 176K 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.
- 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 75,000. Despite an admitted mistake in their methods earlier this year, I always cite their approach as 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).
- 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. From my perspective, the decline in consumer confidence, even with lower gas prices, is disturbing. It is difficult to account for the effect of headlines about Europe and the fiscal cliff.
- Street estimates generally follow my method, but few reveal much about the specific approach. Have a little fun by looking at the specific forecasts from many firms, along with a picture of the spokesperson! Thanks to Business Insider. Joe Weisenthal, in a good story about Goldman, notes that some of these estimates are already responding to the ADP report.
- Briefing.com cites the consensus estimate as 100K, the same as their own forecast.
- Gallup sees unemployment as falling on a seasonally adjusted basis (but flat if unadjusted). 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.
Partial Indicators
A problem with forecasting net employment changes is that you need to look at all of the following:
- Both hiring and firing;
- Companies of all sizes; and
- Failing companies and new businesses.
There are many interesting pieces to the puzzle, but it is easy to over-react without the context listed above. The respected Challenger survey reports fewer layoffs. Excellent! But does that mean hiring? Initial jobless claims move higher. That tells us about job losses at certain types of firms, but nothing about job creation.
An interesting idea comes from Michael Mandel, who astutely notes the disparity in help-wanted ads according to the occupation. Harkening back to The Graduate, Michael (one of my favorite acquaintances from my Kauffman meetings), writes as follows:
“If you have a college student in your family who is looking for a job, remember this one word: ‘Data.’”
For Dustin Hoffman it was “plastics.” Michael says to watch this, so I am and you should, too.
Men on a Mission
(And women too, of course, but I could not resist the alliteration. Biased female economists should feel free to accept equal blame!)
Here at “A Dash” we have great respect for those who make objective, independent forecasts. We know that methods may lead to different conclusions, and that debate is healthy.
With this in mind, here are two examples:
- TrimTabs confidently asserts that the BLS data will be wrong! Amazing, without knowing the content of the report or the revisions. They assert that we are in a “depression” and are confident about the direction of later revisions. While I have been sympathetic to their own mistakes, and agree about revisions, they do not seem to realize that the BLS has been understating growth for a couple of years. Why the agenda?
- David Rosenberg is out with a list of reasons why the jobs report will “stink.” He cites a number of interesting indicators. A serious economist would do research with a time series on each, discarding those that reflected multi-collinearity. That is what my team did. He cherry picks reports and plays the same tune, always finding new data. He has an audience, and one much bigger than mine! [Will someone please remind me of who first said that the crowd expects Neil Diamond to sing Sweet Caroline? I want to give credit where it is due.]
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.
It would be a refreshing change if your top news sources featured any of these ideas, but don’t hold your breath!
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.
I also expect some dampening in either direction. A really bad number will be met with expectations for Fed action. A strong number will get the opposite result, and maybe a stronger dollar.
Unless there is a massive discrepancy from expectations, my guess is that we will move on to earnings season and option volatility will be reduced.
And most important…..investors should not let this become political, even though the pundits will.
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