E-piphany

Are we finally seeing some “green shoots” that are actually green? Or is this just a premature germination caused by unseasonably warm weather (in this case, exceptional Federal spending)?

What many people applauded as “green shoots” earlier in the autumn/summer was nothing more than the ‘dead-cat’ bounce after the exceptionally depressed post-Lehman levels. Into the teeth of the crisis, initial claims for unemployment benefits spiked to a four-week average above 650,000 per week and net Payrolls were contracting at 700,000 per month. When those figures subsequently improved to -550,000 and -300,000, it was hailed as a harbinger of an imminent recovery when all that had really happened was that the economy had returned to its already-bad pre-Lehman trend.

That didn’t stop the equity markets from partying like it was 1999, of course. (What was really impressive about the rally that unfolded, though, was that even once the data leveled off for a while and the Unemployment Rate resumed climbing, stocks kept steady-to-higher.)

The Claims and Payrolls data from the most recent few weeks and months, though, finally give some cause for cautious optimism among people who are not genetically predisposed to be cheerleaders for higher equities. Yesterday’s Employment release, with the exception of one smudge that mars an otherwise happy picture, was the best piece of economic data we have had in quite a long time. Now, partly this is because we have fallen so far that almost anything looks “up” to us, but with the Street looking for a loss of 125,000 jobs on the month, the actual figure was -11,000 and subsequent months were revised higher by a net of 159,000 jobs. In other words, the Street’s “miss” was 273,000 jobs (from -125K to +148k). The unemployment rate unexpectedly dropped to 10.0% from 10.2%, and even the weekly hours figure rose 0.2 hours.

Misses in forecasts are commonplace, but given the noisiness of the data they are not generally large enough to be able to reject the null hypothesis that the real underlying rate was roughly what you thought. But with a miss that large, there is a very real chance that the underlying rate of job loss is currently less than most economists thought. In other words, we can with some reasonable confidence reject the notion that Payrolls are still contracting by 125k or so per month.

Now, hold your horses before getting too excited. Here are some caveats to that good news. First, even if the true rate of job creation is as high as zero – no longer in the realm of job destruction, that is – then the Unemployment Rate is still going to march higher. Even if Initial Claims is really running at the 457,000 level of the latest report, that merely puts it back near (and actually still above) levels that were sustained for extended periods coming out of the last two recessions (see Chart below):

400K Claims pretty common coming out of recessions

Moreover, there is the one smudge that I mentioned. An indicator I have recently grown fond of is the number of people who are not in the labor force (because they haven’t looked for work recently – actively looking for a job is a prerequisite to being considered to be “in the workforce”) but who want a job. Though this series is noisy, it very clearly identified the breakdown in the employment situation and has not yet begun to improve. Indeed, the series reached a new high yesterday, as you can see in the next chart, sourced from the Bureau of Labor Statistics (seasonally adjusted, numbers in thousands).

There are still 6 million people wanting a job and not even looking.

The reason this matters is that when these people start actively looking for work, the first thing they will do is raise the Unemployment Rate (since they will then be counted as unemployed), which will then gradually decline as they find work. In other words, until this series begins to decline, the prospects for a sustained decline in the Unemployment Rate are dim. And, with this many people out there who would like a job, even when the ‘Rate begins to decline it will take a long time before it reaches levels that we have grown to consider acceptable. By “a long time,” I mean four or five years at best.

Now, that doesn’t mean that it won’t feel like recovery – assuming, and these are big assumptions, that the improvement is sustainable without continuation of unprecedented fiscal and monetary stimulus and that the commercial real estate crisis doesn’t cause another shoe to drop and that the sovereign debt crisis remains just a possibility and not a reality. Those are a lot of assumptions…but of course it’s also fair to note that, at the beginning of a recovery, there are always a lot of things that might still go wrong – the point is that if the economy has enough endogenous positive momentum it can deal with occasional setbacks. I have my doubts on that score, but the data currently do have some positive momentum.

Now, the real question for investors as opposed to economists is this: even if these are finally green shoots, it isn’t clear how you ought to invest – because the market already priced in the green shoots when they were just fake green shoots! The fact that the stock market was unable to rally on Friday, in the context of the best economic data we have seen in years, is concerning. Current valuation levels suggest that sustained gains, even if the economy is improving, are far from a sure thing and there is a significant degree of risk if, on the contrary, one of those setbacks happens. I am sure I will return and develop this thought in future posts.