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.

Let'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.

 There 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.

Comments

[oldprof]

Heat Rate -- For starters, let me agree that no one really knows what will happen. Most of the skeptics don't know Econ 101 and they don't bother to study the research.

The concepts involved are explicitly designed to avoid a Japan-like situation. In my annual visit to the Kauffman Conference I have had the good fortune to meet David Beckworth and Scott Sumner. Their work has been influential. The key idea is that the need is for policymakers to change expectations in order to change behavior. We need to accept that the Fed is going to tolerate a higher rate of inflation, defined by their measures.

If we want to make money as investors, we need to accept that as the new reality.

Japan did not do anything like this, and Jim Grant has not addressed it -- at least not where I can see it without paying for his publication.

As to the zombie argument -- well -- if you were President and I was your advisor (or vice versa) we would not have let this happen either. Look back at George W and Paulson. No one with real responsibility thinks this way.

Nice questions.

Jeff

[oldprof]

Thanks, Paul.

Bean counters everywhere should enjoy! I finally had some fun while writing about employment:)

Jeff

[Heat Rate]

I like your style and the way you think.

That said, I would like to drop in the idea that perhaps people have bought in to the idea of QE way too much. The year is 2012 and the Fed is still engaging in QE 4 years after the fact. What does that tell you? Clearly, the problem is not liquidity. A marginal decline in the mortgage rate isn't going to solve a problem of leverage in household, government and corporate balance sheets. Japan has been dropping Yen notes for 20 years. Go take a look at their equity market. Moreover, has anyone taken a look at mortgages rates lately? They have retraced all of QE3s losses and at the end customer front mortgage yields have been rising.

People buy in to the idea that QE will kick start the economy. On what grounds are they making this claim? What are the facts? But of course the pundits will say "well if the Fed did not engage in QE then where would the markets be now?". My answer to that is the economy would be in a robust recovery for the simple reason that markets would have cleared and purged the zombie investments in the system. the reader can refer to Jim Grant's research as it is more grounded in fact than the *experiment* that Fed officials are currently engaged in.

Economics 101 - QE doesn't solve or help a debt problem.

[Paul Nunes]

This is one I am printing and sharing with my political friends. Your teaching of this particular subject deserves way more recognition!