November 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.  Two months ago 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 guess what the BLS will report.

Please read the September 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 November.

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.  This is especially important this month since the official survey response date has been moved forward by a week.  This is a routine adjustment for the Thanksgiving holiday, but it increases the potential for error and later revision.
  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 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 118K 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.  In recent months 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. 
  • TrimTabs looks at income tax withholding data. The idea is that this is the best current method for determining real job growth.  I regularly feature the TrimTabs forecast, but at the time of writing this post they have not yet issued a release.  Their site is here, and perhaps those commenting can help if there is an update.  [Update 12/6:  202K]
  • 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 are generally similar to 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 90K, while their own forecast is for 80K.  Their private jobs
    forecast is much  are about 10K higher, since the loss of public jobs is
    well known.
  • Gallup sees unemployment as increasing dramatically  to 7.9% 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:

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Despite this result, Gallup sees net job creation — yet another illustration of why employment is so difficult to understand.

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 among others — and perhaps not the best.  The bean counter example illustrates
this.

Trading Implications

This week's employment situation report involves major risk factors:
  • There will be effects from Sandy, but these will be difficult to quantify.  The shift in the reporting date will magnify the distortion.
  • Post-election skepticism will dominate the analysis.  Any weakness will be seized upon as evidence that the last two reports were artificially inflated.
  • Those claiming that a new recession has begun will pounce on any weakness.
  • Traders no longer see the Fed as a viable source of support.  We have a new era of good news is good, and bad news is bad.

Conclusion

I expect some temporary weakness from business anticipation of the fiscal cliff and the effects from Sandy.  There is a real danger that the +/- 100K confidence interval could result in a very bad number — possibly even a negative print.

Despite the various adjustment factors cited here, there would be a huge reaction to a bad number.  When the report comes out, no one will take note of the wide confidence interval, or the fact that the BLS methods have understated job growth in the last year.

As usual, even if the report is surprisingly strong we can expect a spin-induced opportunity to buy.

For traders, it is wise to be cautious and short-leaning.

For investors, there may be a chance to buy at irrational prices.

 

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