That loud boom you heard Friday morning coming from the futures pits was the job report imploding the dollar and sending interest rates tumbling. The consensus estimate was for 125,000 new jobs and it came in at a meager 21,000. Most economists think that we need 150,000 new jobs created per month to actually gain ground with population growth.
This signals the potential for a weaker economy in the future, thus interest rates drop. A weaker economy also hurts the dollar, and thus the market reaction. Perversely, the stock market seemed to think lower rates are good for stocks in the future, so the broad market ended up sideways, except sadly for Martha Stewart Omnimedia.
We are going to follow up last week's thoughts on trade with a look at employment and the lack of job growth. These are two of the three critical issues the country will deal with in the coming election cycle, with Iraq and the War on Terror being the third. We are going to look at three different research reports and then see if we can draw some conclusions, as well as look at the magic of numbers from the Bureau of Labor Statistics.
The reasons for the jobless recovery are complex. They stem from a structural shift in the US and global economy, capital labor ratios and productivity, among other factors. It's not just job-outsourcing to China and India, the favorite whipping boys of the month.
Now, I want to put this letter in the context of an economy that is growing by over 4%, where US household wealth hit an all-time high last month, where there is a slight slowing of the rate of increase in household debt growth and that productivity growth is slowing, which as the Wall Street Journal noted "The gradual slowing in productivity suggest that employers are running out of ways to milk their workers for more output and may be inclined to hire more in the months ahead." I recognize that there are a lot of good things happening. We are simply going to focus this letter on one part of the economy where things are not doing as well.
Last week, I argued that productivity was a large reason for the jobless recovery. From that letter: "Here are the facts, conveniently brought to us by Martin Wolfe in the London Financial Times. First, American manufacturer employment has dropped 2.6 million jobs between March of 2001 and January of 2004. By January of 2004, employment in manufacturing was 17% below what it was in June of 2000, the peak month for manufactured output in the last cycle.
"Outsourcing? Offshore manufacturing? On the surface, it seems to be the culprit. It makes for good copy, as it is easy to see a manufacturing plant closing in Wisconsin and opening in Shanghai. But it is not that simple. If we look at the numbers, I think we can find another perpetrator. There was a 17% rise in worker productivity over the same periods noted above, with just a 3% drop in production. We are producing roughly the same amount of 'stuff' with a lot fewer workers. We produce almost twice as much as we did just 24 years ago."
But it is more than that. There are longer term structural changes at work and a shift in the nature of business investment, which we will look at. Plus, I think we can offer a few reasons why consumer confidence is going down, even as US household wealth hit a record high this last month. This has important implications for the economy and public policy and ultimately for our investment portfolios.
The Bureau of Labor Statistical Magic
First, some would argue that we should not be whining about unemployment. It is, after all, only 5.6%, which is historically not all that high. But current headline Bureau of Labor Statistics unemployment rates are not the whole story. The magic of statistics is that if you get to define the terms, you can make the numbers say what you want them to say.
No great conspiracy here, but the unemployment numbers are developed in such a way that unemployment is understated. If there was some conspiracy, we would not be able to look at the detailed way in which the numbers are developed. The fact that most commentators do not look beyond the headline number is not a conspiracy. It is laziness. Big difference.
The unemployment numbers are useful as they give us a direction of employment, which has been improving, and a basis for historical comparison. But there is more when you look at the underlying actual numbers that make up the statistics and how they are counted.
For instance, the BLS does not include people in the category of unemployed who want a job but have not looked for one in the last four weeks. If you add in the people who want a job but are not counted as unemployed, the unemployment rate goes up to 8.8%.
There are also 4.4 million people who are working part-time but would like a full time job. If you add those in also, we have 11.8% of the population who are unemployed or are under-employed.
But the statistics are even more ambiguous than that. If you look at the actual numbers for February 2004 (www.bls.gov) you find that the total number of people classified as unemployed went down by 127,000. Doesn't that mean we created 127,000 jobs?
The answer is no. Let me throw you some odd statistics. First, since November, the actual labor force (according to the BLS) has dropped by over 700,000, even though the population rose. The number of people actually employed dropped by a seasonally adjusted 265,000. The number of people who are now considered not in the workforce rose by over 500,000.
Yes, in the world of government statistics, we can have a rising population, the number of employed go down and still see the unemployment rate drop. We simply use a definition for unemployed which ignores many of those who are in fact unemployed and would like a job.
The number of people not in the work force has risen by almost 1.7 million in the last year. Part of the rise in the number of people not in the labor force is due to retirement, going back to school and other natural forces, but a significant part is simply reclassifying people as not part of the labor force because they have not looked for a job in the last four weeks. The labor participation rate is 62.2%, down by 0.2% from this time one year ago, yet supposedly the unemployment rate has dropped almost 1%.
We will come back to this in a minute, but let's look at some other studies first to give the numbers come context.
The Structure of Unemployment
Many economists are looking at historical charts of recoveries and predict that any day now we will see employment rise substantially. That is because in past recoveries, by 18 months after the end of the recession the employment numbers were soaring. Even in 1991, which was the first jobless recovery, the job growth started later than the typical recession cycle, but eventually took off.
To get a clue as to what's so different now, let's go to a study from the New York Federal Reserve entitled "Has Structural Change Contributed to a Jobless Recovery?" by Erica L. Groshen and Simon Potter. I am going to pull several paragraphs directly from the paper, rather than summarizing, as they do a very clear job for economists in explaining their research. (http://www.newyorkfed.org/research/current_issues/ci9-8.html)
"The current recovery has seen steady growth in output but no corresponding rise in employment. A look at layoff trends and industry job gains and losses in 2001-03 suggests that structural change--the permanent relocation of workers from some industries to others--may help explain the stalled growth in jobs.
"A surge in payroll jobs used to be a reliable sign of the end of a recession--but not any longer. When the National Bureau of Economic Research (NBER), the accepted arbiter of business cycle dating, recently designated November 2001 as the end of the nation's latest recession, it based its decision largely on the growth of output (GDP).1 By the end of June 2003, GDP had risen 4.5 percent from its low in the third quarter of 2001 and significantly exceeded its pre-recession peak. While the members of the Bureau's dating committee saw the strong growth of this indicator as persuasive evidence that the downturn was over, they acknowledged that their decision was made very difficult by the 'divergent behavior of employment.' What troubled the committee was that payroll employment, which would normally rise in tandem with output, had shown no sign of recovery. Indeed, the payroll numbers fell almost 0.4 percent in 2002 and another 0.3 percent through July 2003. In this edition of Current Issues, we explore why the recovery from the most recent recession has brought no growth in jobs. We advance the hypothesis that structural changes--permanent shifts in the distribution of workers throughout the economy--have contributed significantly to the sluggishness in the job market.
"We find evidence of structural change in two features of the 2001 recession: the predominance of permanent job losses over temporary layoffs and the relocation of jobs from one industry to another. The data suggest that most of the jobs added during the recovery have been new positions in different firms and industries, not rehires. In our view, this shift to new jobs largely explains why the payroll numbers have been so slow to rise: Creating jobs takes longer than recalling workers to their old positions and is riskier in the current uncertain environment."
They further explain what they mean by structural versus cyclical change:
"At the start of any recovery, many employers will delay hires or recalls for a time to be certain that the increase in demand will continue. Nevertheless, although the job market resurgence in the past may often have lagged the output recovery by one quarter, only during the two most recent recoveries has the divergence between job and output growth persisted for a longer period. The divergent paths of output and employment in 1991-92 and 2002-03 suggest the emergence of a new kind of recovery, one driven mostly by productivity increases rather than payroll gains. The fact that no influx of new workers occurred in the two most recent recoveries means that output grew because workers were producing more. Although one might speculate that output increased because workers were putting in longer days, average hours worked by employees actually changed little during this and the previous jobless recovery.
"Recessions mix cyclical and structural adjustments. Cyclical adjustments are reversible responses to lulls in demand, while structural adjustments transform a firm or industry by relocating workers and capital. The job losses associated with cyclical shocks are temporary: at the end of the recession, industries rebound and laid-off workers are recalled to their old firms or readily find comparable employment with another firm. Job losses that stem from structural changes, however, are permanent: as industries decline, jobs are eliminated, compelling workers to switch industries, sectors, locations, or skills in order to find a new job.
"A preponderance of structural - as opposed to cyclical - adjustments during the most recent recession would help to explain why employment has languished during the recovery. If job growth now depends on the creation of new positions in different firms and industries, then we would expect a long lag before employment rebounded. Employers incur risks in creating new jobs, and require additional time to establish and fill positions."
They go on to analyze industry by industry the nature of job losses and do indeed conclude that there is a significant amount of structural change. In past recessions, roughly 50% of the job losses were cyclical and thus poised to come back swiftly and the other half were structural. During this last recession, the amount of structural job losses was 79%. Think telecom and manufacturing, as examples, not to mention all the jobs which technology and mergers have eliminated.
The last recession has had to overcome a far deeper permanent loss of jobs than any post-war recession. Given that, we should not be surprised at the job-less recovery.
They give us three reasons as to why there might be such a significant increase in structural job loss. First, over expansion in industries to the enthusiastic boom of the 90's, then the possibility that the Fed actually reduced the problems of cyclical job loss through its easy money policy, and finally the simple decision by management to run leaner operations.
Here is what I think is he central part of their conclusion:
"The largely permanent nature of this recession's job losses could explain why jobs have been so slow to materialize. An unusually high share of unemployed workers must now find new positions in different firms or industries. The task of finding such jobs, difficult and time-consuming under the best of conditions, is likely to be even more complicated now, when financial market weakness and economic uncertainty prevail. In such an environment, firms may hesitate to create new jobs because of the risks involved in expanding their businesses or undertaking new ventures. Some support for this interpretation comes from the findings of the Job Openings and Labor Turnover Survey, which suggest that the current shortfall in payroll growth owes more to low job creation than to widespread job elimination."
Capitalists of the World, Unite
David Rosenberg, Chief North American Economist of Merrill Lynch gives us this observation on yet another reason for a soft labor market: Let's read him in his own words:
"A little while ago, we published a report titled 'Capitalists of the World, Unite' because we had noticed that while this cycle has been sub-par from an employment standpoint, and that's true whether or not you look at the non-farm or household survey, business investment has actually been quite robust. What's interesting is how everyone is focused on China and India as the source of the job market malaise of the past couple of years, and while this is significant, the real story may well be in our own backyard. It is our contention that there is a fundamental shift underway in the capital/labor ratio. In essence, labor is re-pricing itself not just to the extremely low wage rates in China and India, but also to the declining price of capital here at home.
"Invoking the works of David Ricardo, there are two factors of production capital and labor, and the cost of capital as measured by the equipment & software price deflator has hit a 25-year low and in the past eight quarters is roughly down 2%. Over this 2-year span, the employment cost index has risen by almost 8%. Employment costs are not being driven down by the wage rate, which is decelerating, but rather by the acceleration in benefit costs. Benefits, largely healthcare and workers' compensation, now account for over a third of employment expense and is running near their fastest rate in 13 years. The challenge for the household sector is that wages are discretionary income while benefits are targeted.
"While everyone is looking for the answers to this lackluster job market cycle, businesses are actually far from stingy. They are focused on the input that is increasing less costly in the production process, with a focus towards upgrading their tech infrastructure. In fact, real business spending on tech capital expenditures has risen in 7 of the past 8 quarters and at an average annual rate of better than 12%. At the same time, more than 2 million payrolls have been shed and even the household survey shows job creation basically in line with the sluggish upturn in the early 1990s.
"The net effect has been to boost productivity sharply, which is running at a 5.3% year-on-year rate, almost double the pace of two years ago. At the same time, slack in the labor market has helped companies keep a lid on wage growth and as a result we have unit labor costs running at a -2.3% y/y rate. Unit labor costs have the most powerful statistically significant correlation with core consumer inflation, and are a key reason why the Fed can remain accommodative and the primary reason why corporate profit margins have remained wide even in the face of rising raw material prices."
Let's look at some of the implications of the above two pieces. First, obviously, we have permanently lost more than the usual number of jobs for a recession. Structural loss of jobs is normal. But this time it has been much higher than in the past. It is Schumpeter's creative destruction on steroids. Every new innovation changes the relationship between labor and production. Sometimes it allows for fewer people to produce more "stuff." Other times it simply removes the need for products or services, like buggy whips and typewriters. But it still means those who lose their jobs must find new ways to re-train themselves.
Second, as Rosenberg pointed out, it is often cheaper for employers to buy technology than hire new employees. Partially that is because the price of technology is coming down and partly because the cost of borrowing is so cheap.
These two factors are not going away. We are seeing continuing high numbers of lay-offs, much more than one would expect for this point in a recovery. Money is going to be cheap for quite some time. These are headwinds against which rising employment must sail.
What is actually amazing is that the job picture, from the point of view of past recessions and from whichever set of unemployment statistics you look at, is really quite astounding. The American economy has created an remarkable number of new jobs in a small amount of time. If this had been a typical recession, we would now be seeing a significant drop in unemployment. Has it created all we need? No. But given the actual permanent loss of over 2,000,000 jobs, and the on-going nature of large lay-offs, it is remarkable that unemployment is as low as it is.
Of course, if you are the one who is still looking for a job that is of little consequence. The economy will not be seen as amazing until you and your friends have jobs.
Which brings us to our final piece of the puzzle. Gary Shilling has done some excellent research on employment, giving us some very disturbing numbers. The extension of unemployment benefits has given a cushion to many of those unemployed.
But, he notes: "...although Congress extended that program twice, it ran out at the end of 2003 and has not been renewed... it's estimated that in January, 375,000 ran out of unemployment benefits. Unless the [program] is renewed or replaced by another extended benefit program, the total is expected to swell to 2 million in the first half of this year. Want to bet, however, that Washington will sit by idly if unemployment leaps between now and the first Tuesday in November, to pick a random date?"
Ah, but some of the more cynical among my readers might think that this will lead to a surge in employment, as people will go back to work if they have no other sources of income. But Shilling (who no one ever accused of having a Pollyanna gene in his body) gives us a large body of research which shows that this time, that is not the case. While it may have been true in prior times, it is not true today. As it turns out, the data suggests what the real world knows: It is hard to find a job.
"[the research] reveals that the rate at which the unemployed exhaust their benefits used to peak [in recessions prior to 1991] at about the same time as the duration of unemployment. Since the early 1990s, however, the benefits exhaustion rate topped out while the duration was still rising. It may be that in earlier recessions, the leisurely unemployed went back to work when their benefits ran out, but not in the last decade. This lends credence to our belief that the jump in duration of unemployment since the early 1990s fundamentally is due to globalization, the lack of pricing power and cost-cutting that involves job chops, as discussed earlier.
"On balance, then, it does not appear that now or earlier, the duration of unemployment was influenced significantly by the extra unemployment insurance benefits that the federal government almost always institutes in tough times. Rather, added benefits are reactions to slack labor markets of which the time between jobs is an important measure.
"Further, the leap of the duration in recent years as well as it's abnormally high level in the much of the 1990s is probably due to the difficulty of many in finding new jobs in an era of globalization and lack of business and labor pricing power. When both blue and white collar positions are being eliminated permanently, it simply takes more time for people to find new jobs. This may mean that the average duration of unemployment is now a more important gauge of the labor market than the unemployment rate in influencing consumer sentiment and spending as well as voter attitudes."
The average duration of unemployment is over 21 weeks, and was just barely under the all-time highs of last quarter. (I did not ask Gary if this included those who are no longer classified as unemployed because they are not looking for a job, but I bet it does not, which if they were included would make the number even higher. Next week, we will see if my cynical attitude is correct.)
(You can read a summary of this excellent research at www.agaryshilling.com, under INSIGHT newsletter.)
Now, let's examine some of the implications. First, this underscores several of my long time themes. The Fed is not going to raise rates in this environment. Ultimately, without job growth, the stimulus driven recovery is going to weaken. Third, this is going to weaken consumer spending, contrary to what almost every mainstream economist believes. Simply the loss of benefits will put less money in the hands of consumers.
A notable exception is Richard Bernstein of Merrill Lynch. From his February 9 US Strategy Update:
"...look at the relative forecast P/E between Consumer Staples and Consumer Discretionary over the past 20 years. The relative valuation has carved out a cycle during the last 14 years or so, and it turns out that this cycle is a very good contrary forecaster with respect to the health of the consumer sector. In other words, when Staples are priced very expensively relative to Discretionary, then it implies that the market is convinced that the consumer sector will meaningfully weaken. Typically, the consumer has ended up being stronger than investors expected. Similarly, when Staples are very inexpensive relative to Discretionary, it implies that the market is convinced that the consumer will be extremely strong. Typically, the consumer has subsequently disappointed. Currently, Staples remain quite undervalued relative to Discretionary stocks. Investors are once again convinced the consumer will strengthen, but history argues that they might be disappointed."
When and if consumer spending slows down, the stock market is in big trouble.
What can offset this and make consumers spend more? Mortgage rates are once again dropping. This will allow anyone who missed the last round of re-financing to once again hit the piggy bank of increasing home values. The irony is that a weak economy allows for lower rates which allows for increased borrowing and spending. We will have to watch this carefully, as it could be a pre-cursor to another large stimulus.
On the negative side of the ledger, gasoline and energy prices are acting as a huge tax increase. My bet is that the government will soon stop (or at least slow down) topping off the strategic petroleum reserves. They are increasing them quite steadily, and it does put upward pressure on prices. Would Bush open up the reserves to lower prices in the summer as a further stimulus?
The correlation between employment and consumer confidence is quite high. Kerry is going to play upon that uncertainty.
From a realistic point of view, there is not much more the Bush administration can do that will have an immediate effect. They have cut capital gain taxes, which helps foster new business and investment. As Shilling noted, if employment does not improve within the next few months, expect Washington to once again extend benefits.
You can cut regulations and bureaucracy, which is a serious hindrance to capital formation, but that is not going to do anything this year. The time for that to make a difference today was in 2001. We need to really, really re-think our educational system. Vouchers, higher new standards, updated curriculum and less bureaucracy and more teachers and smaller classrooms and a host of other changes. Of course, this makes a difference in 15-20 years, but it is one we must start.
The economy is growing at 4% plus. But if we need to grow at 1% just to make up for population growth, and if productivity is over 3%, that does not make for a surge in employment. Either we must grow even faster, or eventually the lack of job growth is going to slow the economy and create a recession.
On the political from, my bet is that the Bush team argues that Kerry, by raising capital gain taxes, would damage what new business formation there is. Along with the dividend tax cut, it is a large part of the stock market rebound. But that is a difficult and complex proposition to put across. We will see benefits extended and everything that can be done to show those who are worried that they care. And of course Kerry will say that everything they do is either wrong or too little, too late. They will both have huge amounts of money to make their case. It is going to be a long campaign season.
But at least the debate will be as stark and contrasting as any we have seen in years. It will be interesting to see the outcome.
Bull's Eye Investing, Kansas and Sir Walter
While many of the readers of this weekly letter are very kind in their comments, I am usually not happy with the letter. Whenever I re-read it, I see a dozen mistakes and things I should have changed or mentioned, ideas that are completely missing or not as clear as I would like. But that is the nature of writing a letter in about five hours and hitting the send button. There is simply not a lot of time for review or reflection. It is simply me distilling what I read and think of as important that week.
My book has been a far different process. I labored over each paragraph and chapter many times over the past 18 months, often re-writing sections 4-5 times. I finished proof-reading the galley's of my book yesterday. I read it in a few days, trying to get the experience of simply reading it, with as close to fresh eyes as I can.
While there will always be things I wish I could add, in general, I am quite pleased with the book. It is 400 packed pages of research, graphs and analysis that I think will help you be a better investor. The response from those who have read pre-publication manuscripts has been more than gratifying, helping calm some of the pre-publication jitters.
I received these very kind words came from Richard Russell, the venerable publisher of Dow Theory Letters. At 79, he writes more than I do and he does it every day. Now, there is a productivity machine. He has probably put 10 investment writers out of business.
"John Mauldin's widely-heralded new book, 'Bull's Eye Investing' is a breath of fresh air and a treasure trove of market insights and information. When you think you've 'read 'em all,' my suggestion is that you turn to this book. Simply put, "Bull's Eye Investing' provides information and perspective that you will not find anywhere else."
I am off to Kansas City tomorrow for a one night stand. My good friend, Walt Ratterman, is being knighted tomorrow, and I have decided I need to be there to honor the work he has done. You may remember the man I wrote about in December who smuggled medicines and solar lighting systems for hospitals into Myanmar? He is now Sir Walt. And thanks to the generosity of my readers, he will be able to take more needed medicines, food and power back to Myanmar in the near future. (For more info, you can go to www.kbi.org. These are the good guys. They take no salaries and often pay their own expenses. Send money!)
When I look at the contributions of Walt and thousands of others like him who serve around the world, who donate their time, money and energy, not to mention risking their lives to help those who are desperately in need, it gives me one more reason to be encouraged about the future.
And besides, these guys throw a great party.
Your glad the book is done analyst,