August Employment Report Preview

For many years I have written a regular 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 methods.

My preview gives appropriate respect to the BLS, but also to the leading alternative approaches.  I normally write my preview on Wednesday, but this week is different.

1. Because of the Labor Day holiday ADP delayed their private job change prediction until Thursday.  I like to provide information from all sources.
2. Exceptional volatility from other sources reduced the trading opportunity from the jobs report.  Today's market reaction illustrates my concern.
3. There will be what poker players call a "tell." President Obama (who is an accomplished poker player) will give his acceptance speech tonight at the Democratic Convention.  At the time I am writing this, I have not yet seen the speech — but I will be watching closely for hints!

Background

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.

This month is especially discouraging on these fronts.  The New York Times has a typical journalist piece where the author interviews an expert to set up the report.  The author starts with two mistakes.  First, how the ADP has done versus the initial, unrevised BLS report.  At a minimum the distinction should be noted.  Second, the author notes the decline in initial claims this week without noting that this is out of the survey period for the jobs report.

Most important is the New York Times preview of what to watch — and here I think they get it right.  They find two big-name sources on expectations — one from Morgan Stanley and one from UBS.  They agree on a forecast of a gain of 125K jobs, but please note the comment from Maury Harris, Chief US Economist for UBS:

"Maury Harris, chief United States economist at UBS, said that if the
number came in at 100,000 or lower and the unemployment rate stayed at
8.3 percent, that would be a big disappointment for traders. But he said
that anything higher than 150,000 would be a positive surprise."

I do not question either the author or Mr. Harris, but the conclusion is mistaken.  Readers of the NYT should expect that — at a minimum — the column would observe that the sampling error from this survey implies a confidence interval of +/- over 100K jobs.  It shows the advantage of reading blogs and Seeking Alpha instead of relying on mainstream media.

And that is before we get to the various seasonal and benchmark adjustments.

Since the subject is so important, everyone places 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 August.

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 201K 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 185,000.  Despite an admitted mistake in their methods earlier this year, I always cite their approach as worth serious consideration, but I am getting discouraged.  You will have to read the article carefully to see the actual result.  TrimTabs is in denial of their own data, since the facts do not seem to fit their preconceptions about the economy.  I like their methods and I think that their past record is better than they get credit for, but I am getting discouraged about their objectivity.

• 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 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.  Some of these estimates are already
    responding to the positive ADP report.
• Briefing.com cites the consensus estimate as 130K, while their own forecast is for 140K.  Their private jobs forecasts are significantly higher, since the loss of public jobs is well known.
• Gallup sees unemployment as increasing 
  to 8.1% on a seasonally adjusted basis in mid-August, 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, 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 intentionally did not write this article on Wednesday, because I understood the potential for a big day on Thursday via Draghi, and also the lack of data.

For tomorrow, 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.

We can all watch the President's speech to see if there is a "tell" on employment.  I will be watching the futures trading!