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. Last month I explained this with a bean-counting contest. The winner was NOT the contestant who was closest to the correct answer. Instead, the winner had to predict the guess of a fellow contestant.
This is what we do every month. We want to know the truth about the economy. Instead of recognizing that there are several good estimates, everyone tries to predict what the BLS will report.
Please read last month’s preview both for a laugh and a deeper look.
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:
- 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, as revealed in the most recent 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 158K 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. This month ADP is using an improved methodology with a stronger sample. The objective is to improve the correlation with the final print of the employment data. News coverage of this has been terrible. One prominent CNBC anchor suggested that the changes should lead to a closer correlation with tomorrow’s unrevised first estimate. Another suggested that it is a poor time to for them to revise methods, since there are so many conspiracy theorists. Indeed! What does it mean when a private company, attempting to provide strong economic information to consumers like us, should pay attention to conspiracy buffs? This is a change that has been in the works for months. Should it be delayed? 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. Here is a chart of their data — mediocre gains, but positive.
- 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 140,000. TrimTabs thinks that the BLS missed both a spike and employment and a current slowing. They write as follows:
“We believe the BLS’ survey methodology missed the job-growth pop in August and September,” said Madeline Schnapp, Director of Macroeconomic Research at TrimTabs. “Worse still, the BLS’ October estimate will likely miss the current slowdown in economic growth.”
- 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 have improved a lot. The layoffs catch the headlines, because these are big visible chunks of jobs. I do not think we have a good grasp on job creation. The BLS tries hard, but their approach lags on this front.
- 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 this week.
- Briefing.com cites the consensus estimate as 125K, while their own forecast is for 135K. Their private jobs forecasts are about 10K higher, since the loss of public jobs is well known.
- Gallup sees unemployment as declining dramatically at only 7.0% on an unadjusted basis and 7.4% on a seasonally adjusted basis. 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. Here is their chart:
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.
Much of the spinning will center on the unemployment rate. This has so many moving parts — discouraged workers, part time workers, demographic changes, overall labor force participation, household versus employer surveys — that you can make a case for nearly anything if you look at only a single month.
It is pretty clear that employment is improving, but the rate is disappointing. 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. Meanwhile, I am mildly short in trading accounts, and not very worried about that.
The election is more important than the jobs report, but the two are intertwined right now. I am quite sure that a strong number will be viewed as negative for Romney and therefore negative for the market.
The sophisticated investor does not complain about government policy. He includes likely outcomes as part of his investment plan.
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