Key Economic Indicators Point to a Year-End Rally

Key economic indicators continue to point to lukewarm growth, but a double-dip recession in the US remains highly unlikely. More important, analysts and investors have slashed their expectations for growth, setting the table for a market rally into year-end.

The monthly Employment Situation Report released by the US Bureau of Labor Statistics (BLS) on the first Friday of every month is undeniably among the most widely anticipated economic reports in the world. In August total US nonfarm payrolls declined by 54,000, but the figure includes 114,000 temporary workers hired to conduct the 2010 US Census.

Private nonfarm payrolls, a more meaningful metric, increased 67,000–a terrible number by any normal yardstick. At this stage of the recovery, one would expect payroll growth well in excess of 200,000 to 300,000 private jobs per month. But the recent economic cycle is anything but “normal.” The US continues to experience the subpar cyclical recovery that I’ve forecasted for more than a year.

Sluggish US consumer spending ranks among the most important obstacles to a normal economic recovery. Saddled with high debt levels, households are saving more and spending less. In a normal postwar economic cycle, a jump in US consumer spending traditionally turbo-charges growth in the early stages of recovery. That’s not to say that consumer spending won’t recover; rather, growth in spending will be more in line with growth in incomes.

From the market’s standpoint, Friday’s employment report was a positive: the addition of 67,000 jobs was notably better than the consensus outlook of just 40,000.

The expectations cycle has gone full circle this year. In the first half of 2010 economists raised their forecasts for US economic growth and jobs creation in response to a series of better-than-expected economic reports. Initially, that optimism looked to be justified. The private sector added 158,000 jobs in March and 241,000 in April and appeared on a path to much stronger growth. But in May and June the economy hit a soft patch and added just 51,000 and 61,000 jobs in those two months–far below expectations.

The result: Economists began to revise their expectations lower once again. In many cases, revisions in the second half of the year took consensus expectations back to where they were at the beginning of 2010.

We’ve now reached another key inflection point. Expectations for jobs growth in August were finally too bearish once again; economists’ expectations are now back down to levels that reflect the subpar recovery I’ve been forecasted for over a year. More important, expectations are now low enough that there’s a strong likelihood economic data will exceed expectations over the next few months.

The effect is broadly similar to how the market evaluates corporate earnings reports. Stocks often rally when a company reports weak results, provided results are better than most expect. Similarly, the economy doesn’t have to do particularly well to generate a positive market reaction: Key economic indicators need only beat expectations.

\With many anticipating a double-dip recession, the bar of expectations is extraordinarily low.

Also note that economic data rarely recovers in smooth, uniform trends. Economic recoveries often hit one- to three-month air pockets where key economic indicators appear to deteriorate and the market experiences a growth scare. At the same time, recoveries often experience mini-accelerations that last for one to three months, much like what we saw from February through April.

Unfortunately, this subpar recovery is likely more prone to lumpiness than your average postwar expansion; look for more volatility in the quarters to come.

In addition to the headline private non-farm payrolls number, there are a few other key economic indicators I watch carefully in the Employment Situation Report

Key Economic Indicator No. 1: One-Month Diffusion Index

The BLS asks businesses they survey if they plan to cut payroll, grow payroll or maintain the same number of employees. Readings above 50 on the diffusion index suggest that companies are looking to hire new employees. Here’s a look at the most recent data.

Source: BLS, Bloomberg

As you can see, the one-month diffusion index eased in August to 53, down slightly from 56.7 in July. Though off its 2010 highs, the diffusion index remains above 50: Private businesses are looking to hire employees. The readings are highly volatile from month to month, but the overall trend points to continued weak growth in nonfarm payrolls over the next month.

The diffusion index this cycle looks similar to the recovery from the 2001 recession. Although the employment picture was far uglier coming out of the 2007-09 recession, the pace of jobs creation is remarkably similar.

Some investors may recall that in 2003-05, there was significant chatter in the financial media about the “jobless” recovery that mirrors what we’re hearing today. In the recovery from the 2001 recession, it took an unusually long time for private payroll growth to pick up. This cycle looks to be no different. If the pattern holds, we should begin to see slightly better numbers as we head into 2011.

Key Economic Indicator No. 2: Temporary Workers

As I noted in the Aug. 6, 2010, issue of Personal Finance Weekly, “Unemployment and the Economy,” temporary worker hiring historically has been a good leading indicator of payrolls growth. As business begins to stabilize and pick up, many companies remain unsure about the sustainability of the recovery and are reluctant to assume the expense of hiring full-time employees.

To fill the gap, employers typically take two basic steps: They work their existing workforce harder and hire temporary workers to handle the uptick in business.

This cycle the lead time between a pick-up in temporary worker hiring and payrolls growth has been shorter than usual. In addition, the pace of recovery in temp worker hiring has been far larger than normal, reflecting businesses’ uncertainty about future growth. Check out the graph below.

Source: BLS, Bloomberg

The US added 17,000 temporary workers in August, bringing the 2010 total to a solid 206,000. Since October 2009 only one month brought an outright decline in temporary worker hiring. As the chart illustrates, growth in temporary workers has been dramatic and far stronger than during the recoveries that followed the 1991 and 2001 recessions.

Ultimately, this strong growth in temp hiring points to accelerating private sector nonfarm payrolls growth.

Key Economic Indicator No. 3: Aggregate Hours Worked

In many ways, aggregate hours worked reveals more about business conditions than the private nonfarm payrolls number. This measure accounts for both the size of total US private nonfarm payrolls and the hours worked.

As I explained earlier, early in a recession businesses are still unsure whether the contraction is a short-term soft patch or a longer-lived downturn. Laying off workers is expensive, and if the economy is just hitting a soft patch, businesses that conduct mass layoffs might find themselves understaffed.

The result: Companies, particularly manufacturers, cut back the total hours their employees work, curtailing overtime, cutting the number of shifts or temporarily shutting down factories. If the economy picks back up again, it’s a simple matter to ramp up production to meet rising demand.

But if the downturn strengthens, businesses are forced to slash payrolls and lay off workers. This is why a sharp decline in hours worked usually precedes a decline in payrolls.

During upturns businesses tend to work their existing labor force harder before turning to new hiring. Here’s a look at US aggregate hours worked.

Source: BLS, Bloomberg

As you can see, US aggregate weekly hours continue to recover, and hit a new recovery high for this cycle.

Another way to think about this is that aggregate hours and payrolls growth are equivalent. A business can increase output by either working existing employees harder or hiring new workers to pick up the slack. If I work all of my existing workers 20 percent harder, that’s the functional equivalent of adding workers to my payroll.

I realize that politicians would rather see more workers than more productivity, but that’s not the choice companies are making right now. Eventually, growth in productivity will hit a wall, and more of the growth in aggregate hours will need to come from payrolls rather than hours worked. Nonetheless, this is an encouraging trend that suggests as companies gain confidence in growth employment statistics will improve.

Our Top Stock Pick for September

There’s an old joke that heaven is a place where the police are all British, the chefs are French and the engineers German. Hell is where the police are German, the chefs are British and the engineers are French. There was once a kernel of truth to that statement but nowadays I beg to differ.

Last week I flew to London for a university friend’s wedding held in Horsham, West Sussex. Longtime readers know that I’m a hopeless Anglophile and an apologist for all things, British but I’d say it’s time for everyone to take a second look at Britain’s food scene.

The UK, like the US, is a melting pot, a quality that’s reflected in the cuisine. In particular, if you’re a fan of curry, there’s no place better than the British Isles. My favorite spot is by no means a fancy place, but if you’re willing to rough it a bit in order to eat the best curry that ever crossed your lips, check out the original Lahori Karahi on Featherstone Road in Southhall, not far from Heathrow Airport. Make sure you order the Tandoori lamb chops and a massive garlic naan. Also make sure you bring a good appetite.

And when it comes to traditional British food, does anyone actually not like a properly cooked roast beef and Yorkshire pudding? What’s not to like? And that’s not to mention the myriad French and Italian chefs that have made London their home base in recent years.

In contrast, after the wedding, I flew to visit another British friend currently living in Holland. The Netherlands is beautiful as you can see from some of the pictures I posted to my Twitter page, and the locals are among the friendliest people I’ve met in Europe. But I’ve never been a fan of Dutch cuisine. I hope to find some place to change my opinion on a future trip.

This time I took a one hour train ride across the border to Antwerp, Belgium where I met up with Yiannis Mostrous, my partner in Stocks on the Run. Yiannis selected an outstanding restaurant where we spent the next three hours discussing the market and our favorite stock ideas for the next few months.

I’m really excited about our latest pick, due to be released next Tuesday, Sept. 7. Trading at about $12 per share, our latest recommendation offers a dividend yield of more than 11 percent. But this isn’t just some slow-moving stock in a stagnant industry; conditions are rapidly improving, and management has a policy of paying out substantially all excess cash flows in the form of quarterly dividends.

The bottom line: I expect the quarterly dividend to increase from $0.34 per share to $0.40 per quarter when the company pays its next dividend in mid-November. And I expect the payout to hit $0.50 per quarter within the next year. If the yield remains at 11 percent, the stock should shoot up to about $18 per share. And if market conditions improve, I see this small-cap stock trading at $22 to $25 per share over the next six months or so. That’s a double.

If you’d like to hear more about this high-yield, high-potential pick, as well as a great restaurant recommendation for your next trip to Belgium, Stocks on the Run costs just $5 per month, a minimal fee to defray the costs associated with running the service. Click here for a risk-free subscription.