The Unemployment Quandary

John Mauldin | Thoughts from the Frontline
February 6, 2004

This week we tackle some rather odd discrepancies in the employment numbers - are we adding jobs or losing them? Then is there a relationship between those numbers and the stock market? Are businesses getting ready to hire and spend money? All good questions, and I will try to shed some light on them as we see if we can fit some rather disparate pieces of the information puzzle together to form a picture that we can recognize.

First, there are two different sets of employment numbers. One, the establishment survey of the Bureau of Labor Statistics (BLS), shows we have lost about 3,000,000 jobs since the start of the recession. This survey is a result of looking at the unemployment insurance accounts of about 160,000 businesses (establishments, and thus the name of the survey) at over 400,000 different locations, which covers about 1/3 of all employment. If you are a Democrat presidential candidate or of that persuasion, this is the number you feel is most important. I should point out that if Al Gore were president, this would most certainly be the number repeated daily by those running in a Republican primary.

Then there is the household survey. This survey is conducted by the Census Bureau on the behalf of the BLS. They survey 60,000 homes to see who is working and who's not. This shows the unemployment rate dropping from 6.3% at its height to today's 5.6%, adding 1.8 million or so jobs to the economy.

This is, of course, a huge difference. The difference between the surveys is as wide as it has ever been and by a significant margin. Let's look at my guess as to why.

The establishment survey looks at current businesses that are established enterprises. They do not count new businesses within the last year or self-employed. The household survey calls a home and asks how many people in the home are working.

In the household survey, "People are classified as employed if they did any work at all as paid employees during the reference week; worked in their own business, profession, or on their own farm; or worked without pay at least 15 hours in a family business or farm. People are also counted as employed if they were temporarily absent from their jobs because of illness, bad weather, vacation, labor-management disputes, or personal reasons." (BLS)

You can see the mountains of information on the surveys and the explanation at http://www.bls.gov/news.release. Let me go through a few numbers with you.

First, anyone over 16 who works is counted. Your teenage kids working in the summer are counted, which is why the actual numbers shoot up in the summer. Looking at the actual numbers, jobs actually dropped about 800,000 from December to January. But year over year, there is job growth of about 1,000,000 from January of 2003. Without seasonal adjustments, the numbers would look silly from month to month.

Now, since January of 2002, there have been 1.8 million or so jobs created on the household survey, or about 75,000 per month, which is pretty anemic as recoveries go. It is widely accepted that we need employment growth of 150,000 jobs just to make up for increases in population. Hence, the talk about the jobless recovery.

But in the last six months, the pace has picked up. According to the survey, we have added 599,000 jobs which is about 100,000 per month. This month we saw an increase of about 112,000. (Given Bernanke's promise of jobs growth in his speech yesterday, many felt he had an advance peek at the number. Evidently, he did not. It was just the usual Fed happy talk.)

This month, health and education made up 20% of the growth in jobs. Two-thirds of the jobs growth was in retail sales, which is a seasonally adjusted anomaly. As I noted a few weeks ago, retail businesses did not add workers during the last quarter, so seasonal adjustments showed them actually dropping workers. But what about the huge gains this month? Are they hiring? That explains part of it, but most of it is simply a seasonal adjustment. Since retail stores did not hire lots of extra workers for the Christmas season, it also means they did not let them go. The trend in manufacturing jobs still remains down, but not as much, although the sector has lost jobs for 42 consecutive months.

Show Me The Jobs

There are now 1.5 million more people who are not considered to be part of the workforce than there were last year at this time. Part of this is due to population increase, but much of it is what the survey calls discouraged workers. If you are discouraged and not looking for a job, you are not considered unemployed. Only those actively looking for jobs are considered unemployed.

So, how do we explain the difference of three millions jobs between the surveys? Much of it is because if you say you are self-employed, then you are employed. Were you laid off and then decided to become a consultant? Working part-time? Decided to start a new business? Welcome to the world of the household survey employed. The Employment Policy Foundation tells us that half the household survey job growth since November 2001 is self-employed jobs.

But my friend Bill King is skeptical of that. He goes to the tax tables at the IRS and notes that self-employed taxes rose only 2.2% for 2002, which is less than GDP and inflation. Further, there is little in other tax receipts to suggest a large boom in self-employment.

I called him to go over his data, and think I see a different issue.

It is not that there is not in fact a large increase in the number of the self-employed. There is. It is just that there is not a large increase in the profitably self-employed.

Those of us who are serial entrepreneurs know that the first year of a business is not likely to be profitable. Thus, it is reasonable that no increase in the tax results would show up. Further, the newly self-employed build up carry-forward losses which cover future earnings.

Follow me here. Unless the current wave of self-employed is significantly better than their historical forebears, 80% of them will fail within five years. It's the business Law of the Jungle.

Now, several thoughts follow from this. First, there were a larger than usual number of new self-employed and businesses started over the past two years. That means that in the future, there will be a larger than usual number of those people going back into unemployment or needing and finding another job.

Second, some of the 20% who do end up founding real businesses will employ many of the people who did not make it. But this is not a smooth process. It is the transition that is difficult.

On an optimistic note, Hermann Vohs at Cales Investments notes that business profits are rebounding. (Of course, we are not yet back to where we were in 1998.) Corporate net cash flow is at all time highs, and business capital investment is close to the peaks as well. He notes commercial loans at banks are at last showings signs of stopping their decline.

All of this should translate into jobs over the next year. But I think the wildly optimistic projections we read are not in the cards. Treasury Secretary John Snow staked his reputation on the economy creating 200,000 jobs a month, as an example. Others are even more optimistic that we will soon see massive new job creation and a lower unemployment number.

The Self-Employment Dilemma

Well, maybe not. First, as noted above, there are many "self-employed" and underemployed who will need jobs and take them, leaving the pleasures of being self-employed to others. Further, as the economy improves, those who are so discouraged that they are not even looking for work will once again start the process, adding to the labor pool.

Plus, businesses are reluctant to aggressively hire. John Chambers of Cisco noted "...as soon as we can get another 10-14% on revenue growth, then I will start to hire again." The orders they are seeing are for replacement or productivity. Productivity is good for business and profits, but does not mean a lot of new jobs. Many other executives echo his sentiments. With outsourcing available, and technology allowing for more productivity, the number of new jobs created will continue to be less than for previous recoveries.

I know this will shock readers (not!), but I think this year will be Muddle Through in terms of job growth. We will be creating jobs, but not enough of them to offset the numbers of self-employed who will want jobs with the certainty of a paycheck to significantly dent the unemployment rate. Add in the need for new jobs to cover the increase in population and discouraged workers who will want a job if one can be found, and the unemployment rate will drop more slowly than one would like. It should continue to drop for the next few quarters, but we will not see an unemployment rate below 5% for some time, if at all, this cycle.

But even as it drops, incomes are at risk. Unit labor costs fell 1.7% in the fourth quarter. "All evidence shows employee benefits costs are increasing sharply so either jobs or wages had to be cut, possibly both. And that's not good for the economy." (Bill King.)

Hermann Vohs sums up my thoughts better than I can, so let's go to his note from this week:

"So, while the economy is firing on all cylinders, inflation seems under control and the upcoming elections virtually guarantee no nasty surprises from Washington, the stock markets should be doing just fine, right?

"Let me put it this way. Stock markets climb a "Wall of Worry". In other words, no more worries, no more climbing. The worries that this market had to overcome during the last 4 quarters were the Iraq war, capital spending that was virtually non-existent and last but not least the weakness in the labor markets . Any one of these factors were at one time considered to pose the ultimate danger to the economy and the stock market. Now that only the labor market is left, one might get worried about the future of this market.

"Corporate profits could rise in part because corporations were not hiring. The increased sales were achieved with staffing levels that essentially had not been changed for three years. However, corporations are increasingly bumping up against capacity ceilings. If they want to increase sales substantially above current levels, they need to start hiring and training new employees. Training new employees costs time and money and still does not give you the same bang for your buck like experienced workers do. The result will be rising sales, yes, but potentially lower profit margins. Lower profit margins automatically will engender lower Price/Earnings Ratios which means lower valuations, even when gross profits continue to rise.

"So let's put it this way: Once the last piece of this wall of worry (unemployment) has been conquered, the party will be essentially over. Falling unemployment removes the incentive for Greenspan to keep his (current) boss happy and enables him politically to raise interest rates. Rising interest rates and falling corporate profit margins (even when squared off against rising overall profit levels) might put pressure on stock prices. When will all this doom and gloom begin to occur? My guess is that it will not be a uniform but a gradual development and that we still have a good quarter or two ahead of us. Increasingly, however, we will have to become more and more selective. The good news is: There is always a bull market going on somewhere in this world. The trick is to figure out where and when to get in and out!"

Let me give you one more quote from the bond king himself, Bill Gross. I find his monthly work part of my "must-reads." You can see him at www.pimco.com and I commend his entire article to you.

"As real short rates climb from negative to only slightly positive (PIMCO's longstanding forecast), this reversal in trend will be enough to call a halt to the higher and higher productivity of debt in a finance-based economy. Simply put, it means that borrowers will pay more in real terms, affecting consumption, home building and buying, business investing, and government deficits alike. The lower real interest rate "wind" at their backs will instead turn into a mild headwind. The economy will slow. It may falter. The timing is uncertain. For contrary thinking, pessimistic investment managers or economists, "someday" is often frustratingly "out there" like some phantom force in the X-Files. Still, it suggests caution as we move inexorably closer to our High Noon.

"Readers wishing me to get to the bottom line or even jumping ahead of me to draw their own conclusions may find this "High Noon" parallel a little bit hard to digest even in PIMCO terms. Have I not been preaching the inevitability of "reflation," recommending TIPS and commodities, advocating shorter than average durations filled with intermediate maturities to take advantage of the carry trade? That I have - but reflationary attempts by Fed Chairman and Presidents alike do not presuppose successful reflation in terms of economic growth. The pace of future growth is the true conundrum, not the obvious reflationary efforts of governmental authorities to generate it. Believers in past Keynesian successes and promises of future helicopter droppings [of increased money supply and cash - John] are confident it can be done - that our U.S. and global economy can ultimately exhibit stable long-term growth rates with the government's wind at its back. I have my doubts. Keynes like Volcker conjured his magic in a simpler manufacturing/agricultural based world. In a finance-based economy it is the growth in leverage as well as its costs that call the shots. And a true vigilante, a lender who lends money not as a participant in some money management game or contest, but with the expectation of getting his or her money back in inflation-adjusted terms and then some, will demand that the growth of leverage cease and/or that its cost increase to reflect the increased risk. Either demand will force this economy to retreat. Risk markets will be at "risk" should we move towards this outcome. And too, Treasury interest rates may then ultimately fall instead of rise as reflation fails and debt deflation takes hold. But that is a story/movie for another year and that tale's telling demands the reincarnation of a host of vigilantes long since stripped of their common sense and their ability to say no."

Gross has been turning rather bearish of late. But he makes a point in line with my longer term forecast. The economy has been stimulated beyond anything we have ever experienced. And it only produced a mere 600,000 jobs. Growth in personal income is barely keeping up with inflation and certainly not keeping up with the growth in debt or debt service. Debt cannot continue to grow faster than the economy or incomes, and growth in debt is needed to keep the economy growing.

Sustainable growth will require growth in both jobs and income and less reliance on debt. So far, this has not happened. This is still a steroid economy. But it is difficult to see from where the next round of stimulus comes. The markets and the economy are priced for perfection. But things just don't look perfect to me. As I wrote last month, the markets could continue to move sideways to up, but I think we could see this year as a classic "Sell in May and go away" year. I would have fairy close stops on any trading accounts.

I still think the economy is good to go for at least the first three quarters of the year, and possibly into next year. But unless job growth begins to manifest itself, this economic recovery is not sustainable much over the longer term.

Wall Street Meat

Andy Kessler, analyst, hedge fund manager and venture capitalist has written a booked called Wall Street Meat . It is about his experiences with Jack Grubman, Frank Quattrone, Mary Meeker and Henry Blodget, among others. He really gives you an idea of the real world of the Wall Street analyst.

Kessler recently sent me the book, and I called him not much later to complain that he cost me almost a day, as I was forced to read every word almost as soon as I started, thereby neglecting other duties. I couldn't put it down. It is one of the funniest and more intriguing books I have read in a long time.

I should warn readers that this book is not meant for little old ladies and Baptist preachers. Its language is the rough verbiage of Wall Street trading floors. That aside, it confirmed many of my own suspicions and opened my eyes to much that I did not know. It was worth the day.

Up To My Chest in Snow and Sand

I must finish this letter early, as I rush to the airport to fly to Miami for the Managed Funds Conference. Quite the contrast from last week when I was in Lake Louise in Canada. On Saturday, I found out what it is like to plow a snowmobile into four feet of powder and then try to lift it out with snow up to your chest. But it was the most beautiful place (at least in winter snow) that I have ever been. I assume that this weekend the only thing up to my chest will be either sand or the Jacuzzi.

Your getting ready for the beach analyst,

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