July Employment Report 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 (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 July.

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. (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 163K 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.

• 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 115,000.  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.  The initial claims were weak during July, as was consumer confidence.
  • Street estimates generally follow my method, but few reveal much about the specific approach.  Some of these estimates are already responding to the positive ADP report.
• Briefing.com cites the consensus estimate as 105K, while their own forecast is for 100K.
• Gallup sees unemployment as falling  to 7.7% on a seasonally adjusted basis in mid-July, 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.

The Impact of Revisions

We have been studying the revisions in the BLS reports, as well as the success of alternative methods.  We know that the BLS approach under-estimated the decline in employment in 2008.  Comparing the original estimates to the final report from the state data (the benchmark revisions) is a good way to analyze this.  Here is the picture from 2008:

As you can see, the initial reporting was missing the final benchmark result significantly, with an upside bias.  Now let us consider 2011.

Once again, you need to compare initial to benchmark.  The benchmark revisions after September will have more changes.  The pattern up to that point shows a consistent under-estimate in the initial report.  This helps to illustrate why I believe that we should be giving some credit to alternative approaches.

Each method of estimation should be compared to the final data.  This is an ongoing project for us.  More soon.

Temporary Workers

This month I am introducing an interesting new source, IQNtelligence.  They specialize in real-time analysis of temporary workers, drawing from worldwide inputs from major companies.  Because of the sources, I expect their data to be more accurate than that from the official report.

IQNtelligence specializes in specific trends adapted to market sectors and regions, but it is also a great source for those of us with more general macro interests.  Take a look at this chart of trends in temporary employment.

 

The conventional wisdom is that temporary jobs are a good leading indicator for permanent jobs -- companies taking a conservative first step.  In the current climate, we might question the old relationship for two reasons:

1. Uncertainty over employment costs and benefits (regulations and Obamacare).
2. Uncertainty over economic prospects.

As the uncertainty is resolved, there is great potential for permanent job creation. We will look for more insight from this source on this crucial question.

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.  Despite what some believe, the Fed did not have the employment data available for today's decision, so a weak number will be important for FOMC policies.