Sunday, April 9, 2017

The Curious Case of Friday's Employment Report

Labor markets are still tight
The labor market may be indicating an inflection point
The timing of the inflection point would be unusual
The implications would be far-reaching

Every once in a while employment reports get interesting. Most of the time, the various reports on employment are straightforward.   When different reports on employment are consistent, they are easy to interpret. But that's not always the case. The report 4/7/2017 for the month of March was one of those reports that requires more than a superficial review.

The WALL STREET JOURNAL on 4/8/2017 in the “Heard on the Street” section included an article entitled “Data Obscure Tight Jobs Market.” The theme of the article is that Friday's report can be subject to two different interpretations depending upon which source of data is considered more important.

It states “The best way to understand Friday’s employment report is to ignore the jobs number, which was lousy, and the unemployment rate, which looked good.” For those who missed the report it showed the economy added just 98,000 jobs last month, below expectations and well-off of the previous months’ gains. The contradiction is that the report also showed that the unemployment rate fell to 4.5% from 4.7%.

The article starts by pointing out that the best way to understand Friday's employment report is by ignoring some of the actual data items. Instead of trying to focus on either number, the article suggests focusing on differences in the implications of data from different sources. Unfortunately, the article limits its focus to just the Friday report.

The jobs number comes from a survey of businesses (with various adjustments made by the Department of Labor), while the unemployment rate is calculated from a survey of households which also contains a measure of employment gains. So the two numbers actually come from different reports. The approach of comparing different sources is definitely on target, but there's no reason to restrict attention to just the Friday report. On Wednesday there was unemployment report on private sector employment as estimated by Moody's Analytics using ADP data. On Thursday there was a report on new claims for unemployment insurance.

Labor markets are still tight

From the Friday report:

(1) The drop in the jobless rate occurred even as more people entered the labor force. In other words, the labor market is tight enough to be drawing people into employment who previously were not seeking work.

(2) An alternative measure of unemployment as well as underemployment, which includes those who have stopped looking and those in part-time jobs who want full-time positions, dropped to 8.9% in March, down from 9.2% the prior month and the lowest since December 2007.

(3) Similarly, there was a continued decline in the incidence of long-term unemployment.

(4) In another sign of labor-market tightness, average hourly earnings rose 2.7% from a year earlier. This indicates that the people who are finding employment either by entering the labor market or upgrading from part-time employment are not being forced into desperation jobs. They are probably abandoning desperation jobs for jobs that are more appealing.

(5) The survey of households, upon which the jobless rate is calculated, showed a large gain in employment— 472,000 for the month. There are reasons to believe the household survey is a more accurate measure this month. The difference in magnitude may be due to differences in definitions, but the relative size and direction of change is probably more accurately reflected in the household survey (as discussed below).

(6) The weak job growth number comes from the employer survey. A winter storm struck during the Department of Labor's survey week. People who missed a paycheck that week more often than not would not be counted in the business survey. However, in the household survey people who miss work because of the weather still get counted as employed.

From other employment-related reports:

(1) Unemployment insurance filings reported on Thursday show that the number of people applying for new unemployment benefits fell in the week ended April 1. Initial jobless claims decreased by 25,000 on a seasonally-adjusted basis. As the WALL STREET JOURNAL pointed out on 4/7/2017 in its “U.S. WATCH” section, last week’s report points to consistent job creation and certainly precludes the possibility of major layoffs on a large scale.

(2) On 4/6/2017 the WALL STREET JOURNAL reported on the employment report generated by Moody's Analytics and ADP. As pointed out in the article entitled “Hiring Robust in Private Sector,” private payrolls across the nation rose by 263,000 last month. Using payroll records and an alternative definition from the BLS survey avoids the weather impact that showed up in the Department of Labor's Friday's employment report. Thus, the ADP number is a better reflection of the underlying state of the labor market.

The labor market may be indicating an inflection point

A divergence between the jobs report from the employer survey and the employment component of the household survey can be a random fluctuation attributable to differences in samples and methodologies. However, occasionally it is a very telling sign of the change in the underlying dynamics of the economy. Consequently, “maybe" is the appropriate way to interpret this section. This can only be a “maybe,” but it's worth considering because it would have major implications because of the timing.

As has been pointed out a number of times in this blog, the household survey captures people who become self-employed, start businesses, or are hired by small companies. They generally aren’t counted or are undercounted by the employer survey. In fact, trying to get adjustments to the survey to reflect the undercount in business startups and small companies has been an ongoing problem for the Department of Labor.

Self-employment, business startups, and small business hiring have all been weak spots in this recovery. If those three sources of employment growth have finally kicked in, the economy has undergone a fundamental shift in the sources of growth. While still tentative, there is evidence that such a shift is occurring.

First, from the ADP report quoting directly from the WALL STREET JOURNAL article: “Most of the job gains came from small businesses, defined by ADP as companies with 49 or fewer employees. These firms added 118,000 jobs. Midsize firms with 50 to 499 employees added 100,000 workers, while large businesses added 45,000.”

It's no secret that small businesses are a major source of employment growth. However, the ADP report shows that they are now starting to respond in their traditional role as job creators rather than as the punching bags they seem to have been during most of this recovery.

Second, it's also no secret that the drop in the number of startups during this recovery has been frightening. It's been characterized as a “collapse” in startups. It has surfaced in numerous data sources including IPOs, new business registrations, and tax filings. Unfortunately, the most reliable data on business formations (tax filings) is only available with a lag.

Contrary to the Wall Street focus, new business formations usually originate below the financial radar. Individuals go out and start a business. Only later is a clear that they did more than just become self-employed. So, the fact that employment rose while the unemployment rate fell is significant. That phenomenon, in combination with low growth in the jobs number, is often associated with an increase in self-employment.

The timing of the inflection point would be unusual

A posting on August 4, 2010 entitled “An Article about a Fiction and theEmployment Report” noted that: when the business cycle is just turning up, a divergence between the jobs number from the employer survey and the employment figure from the household survey would indicate a normal recovery. The reason is simple: as confidence increases, and John Maynard Keynes’ animal spirits surface, people are more willing to start a business or try self-employment. Further, as that posting noted: “Recoveries don’t come from having the same set of employers hire back people. Recoveries have always come mainly from new or different companies hiring. Interestingly, it tends to be smaller companies and often startups from the current or the last cycle.”

However, as noted above, new business startups have collapsed during this recovery. The divergence never showed up. So, if next month's employment report confirms the divergence that appears to have occurred in Friday's data, the timing would be quite unusual. It's usually a phenomena observed at turning points when the cycle turns positive.

There are reasons to believe that phenomenon is real. Business confidence surveys ranging from surveys of small businesses to announced hiring plans of the large businesses would be consistent. They all show an increase in optimism. Even more telling for the particular data we’re discussing is the increase in consumer confidence. Self-employment is very much a function of consumer confidence.

The implications would be far-reaching

The divergence might not persist. The normal interpretation of such a divergence could be wrong given that it's occurring at an abnormal point in the business cycle. However, if it is real and the normal interpretation is appropriate, it has major implications across a variety of areas.

Economic Implications

(1) It has cyclical implications. Resurgence in small business, startups, and self-employment this late in a recovery would, at a minimum, indicate a need to rethink where the economy is in its recovery. Perhaps this cycle lasts longer than is typical or maybe it will just require a different kind of shock in order to produce a downturn. Or, perhaps the recovery is just now gaining its footing.

(2) It has structural implications. As noted in the WALL STREET JOURNAL on 4/7/2017 in a special "In Depth" section under the title “Why You Work for a Giant Company,” the US economy has undergone a transition from being largely composed of small businesses to one dominated by large businesses. A revival of small business at this point could reverse the trend and restore the structure that was characteristic of the US economy historically.

(3) It has growth implications. The lack of productivity gains during this recovery is a major concern. Without productivity increases it is very difficult to get wage and income increases. Not to demean the research done by large companies, but traditionally startups and new businesses have been responsible for much of the growth in productivity. Federal Reserve Board in one paper estimated that changes in the number of startups create a persistent increase in GDP through productivity growth. Specifically, they found that a one-standard deviation shock to the number of startups led to an increase of real GDP culminating to 1-1.5% and lasting 10 years or longer.

(4) It has policy implications. The divergence between the household survey and the employer survey would indicate that the labor pool is deeper than superficial employment measures indicate. Thus, inflation is less of a risk than superficial employment measures imply. In essence, if this age of the business cycle is “younger” than its chronological age, then perhaps fiscal stimulus is appropriate.

Investment Implications

(1) As financial markets seem to have surmised, the headline number (98,000 new jobs) is meaningless. It's one of those flukes that show up in any series. It is worth noting that previous postings have argued that trying to invest based upon monthly employment numbers is a fool’s errand. Even if it was a valid measure of employment, a couple more months’ of data would be required before one could surmise that it's a trend. Then one would have to conclude that the employment trend has implications for future profitability. That would be a reversal of the way the economy actually works. Employment is a lagging indicator.

(2) Since the headline number is meaningless, any investment implications arise from the discrepancies between the different reports. Since interpreting those discrepancies involves a lot of “maybes,” there is considerable investment risk associated with making any asset allocation decisions based upon currently available employment data. Now, that's not unusual given that employment levels are a lagging indicator.

However, employment levels aren't the same as structural changes in the economy that are reflected in employment data. Employment data may be the first indicator of structural changes. Most leading indicators provide little or no information about structural changes. The best leading indicator on structural changes is new business formations by industry and size. It is only available with a considerable lag. Thus, even if the phenomenon (new business formations) leads, the data lags.

(3) The issue is investment implications, not speculative implications. Consequently, structural changes are extremely important since they tend the last over a reasonable investment horizon. They are persistent; there's no harm in waiting for confirmation of the implications of the current employment data. The advantage of identifying the structural implications of the current employment data is that it points to a potential trend. Trends are a much better basis for investing then cycles.

(4) Trends are such a firm foundation for investment decisions that most commentators are willing to jump the gun and call any two points a trend. There is a risk of making the same mistake with regard to the structural change being discussed here. There are, however, two differences.
Structural changes are very different from changes in direction in a cycle. Structural changes only appear dramatic after-the-fact; they are subtle while they are occurring. Thus, changes in the direction of the headline number seldom provide any information about structural change. The composition of economic activity revealed by the detailed data is where structural change can be identified. 

(5) Acting on the investment implications of this potential structural change does not have major negative implications if the structural change never appears. To illustrate, a posting on February 11, 2014 introduced “The Three FundPortfolios.” Subsequent postings on the topic provided the rationale and examples of individual funds that can be used to construct a portfolio. One objective of the three fund portfolio is to get exposure to small and medium-size companies without having to select a portfolio of individual companies.

A simple strategy to capitalize on any structural shift toward small and medium-size companies would be to increase the assets allocated to mutual funds targeting that asset class. A posting on February 4, 2016 entitled “The ThreeFund Portfolio in 2016” discussed the ongoing management of the portfolio. It recommended dollar cost averaging into the portfolio. One could capitalize on any structural shift toward small and medium-size companies by targeting the new investment into the mutual fund containing small and medium-size companies.

Dollar cost averaging is a good example of an approach that reduces the risk associated with investing based upon any thesis (i.e., forecast). If the forecast doesn't materialize, as actually was the case with respect to developments in 2016, dollar cost averaging allows one to respond. With respect to the structural change being discussed in this posting, after a few months' of allocating new investments to the fund targeting small and medium-size companies it should be apparent whether the structural change is actually occurring. If it is, one has the option either to continue investing in that mutual fund on a monthly basis or accelerate the rebalancing toward that mutual fund. Given the “maybes” associated with structural changes, dollar cost averaging is a low risk approach to a potentially important investment opportunity.

Friday's job report at first seemed to muddy the water regarding the trend in employment, but on close examination, the issue raised is more subtle. The headline number in the employment report is seldom justification for changing one's financial plan. But, the report does provide information about the performance of the economy. Often that information is just a lagging indicator, but sometimes it reveals underlying trends that has not shown up in other data. When that is the case, it does create opportunities for investors.

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