The economy added 166,000 new jobs last month, almost double the average estimate. GDP for the US came in at a blowout 3.9% growth, well above trend. The Fed cut its rate by another 25 basis points, but many observers see language in the accompanying statement which they think suggests the Fed is done with cutting, at least for now, as the economy appears stronger.

But appearances can be deceiving. This week I lay out a partial case for why the Fed will cut again and yet again (all the reasons would take a book). There are good reasons to doubt the jobs number, but unless you get into the details of how the number is created, you might never know. "Laws are like sausages, it is better not to see them being made," said Otto von Bismarck in the late 19th century. I would add to that list government statistics. While this week's letter may not be for the squeamish, we are going to look into how the sausage of the jobs report is made.

Payroll Survey Sausage

The Federal Reserve Open Market Committee cut both the Fed funds and discount rates by 25 basis points. As is customary, they also released a statement, with the typical five paragraphs, to give some perspective on the action they took. Two of the paragraphs are pro forma, so the meat is in the middle three. A great deal of attention is paid to how these paragraphs change from meeting to meeting. Let's look at some of the changes:

Last month they said that "Readings on core inflation have improved modestly this year." On Wednesday they said, "Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation."

In the September meeting they wrote: "Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."

And the last Wednesday: "Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction."

It is clear they are concerned about inflation, irrespective of the Commerce Department saying it was only 0.8% last quarter. (How bogus!) Numerous commentators read into the statements on inflation and the credit crisis seeming to get better, that the Fed is signaling it will not cut rates at its December 11 meeting. Further, there was one vote on the committee to not cut rates, so there is some discussion in that direction.

However, I think the important sentence is the last one: "However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction."

If the economy is slowing, then the Fed will cut and cut again. "But John," I hear you ask, "the economy is not doing that badly. There were 166,000 jobs created last month, over double the average estimate."

Well, maybe. The Bureau of Labor Statistics actually does two different surveys. One is called the payroll or establishment survey, which is comprised of calling approximately 160,000 businesses (out of 9,000,000) and seeing how many workers they have that month. They survey enough businesses to cover about 1/3 of non-farm employees. And that should be enough to get a good idea of where things are going, right?

Close, but not exactly. They do not contact very many small businesses, and of course cannot call new businesses. And since small and new businesses are the engine of job growth in the US, it is important to include an estimate for them. And they do this by estimating the number of new jobs in various categories that are created or lost in something called the birth-death (BD) ratio.

The BD ratio estimate is based upon past history. While estimating the most recent month's employment picture is quite difficult, you can do a fairly accurate job when you go back a few years, using other government data, tax information, etc. And so you can create a trend for how many jobs you miss due to the birth and death of jobs in the small business area. Now, remember, that number is an average of many years of history.

But there is one flaw in this methodology: it will tend to underestimate new jobs when the economy is recovering from recession and overestimate them when the economy is slowing down. Thus, in 2003-4, the Democrats were beating up Bush about the jobless recovery. As it turns out, those employment numbers were massively revised upward a few years later. There was in fact a powerful recovery going on, just not in the statistics. However, nobody but a few economic geeks paid attention, as it was last year's news.

Now, I mentioned that the Bureau of Labor Statistics does two surveys. The other one is the household survey, where they simply call 60,000 homes (at random) and ask how many people are in the home and who has jobs (part-time or full-time), does anyone want a job who doesn't have one, and so on. This survey covers people who are employed both by large and small employers, illegal immigrants, etc.

These surveys tend to parallel each other, except at turning points in the economy. Then there can be some large discrepancies. As an example, take this month's household survey.

When a Positive 166,000 Jobs Number is Really a Negative 211,000

According to the household survey, there was no growth in jobs last month. "The labor force contracted by 211,000, total household employment fell by 250,000, and employment adjusted to match the payroll concept was off by 55,000. The year-to-year gain in adjusted household employment is 0.7%, compared to 1.2% for the establishment survey, a gap of 0.5 point; just six months ago, the household measure was 0.6 point ahead of the payroll number." (The Liscio Report)

Let's put aside the fact that 166,000 jobs is not enough to keep up with growth in the population, and certainly well below the average for the past four years. Let's look at how the establishment survey found 166,000 jobs when the household survey says we lost 211,000. To do that we need to go to the birth-death ratio. Below is the table from the BLS web site. (http://www.bls.gov/web/cesbd.htm)

In October, the BLS added 103,000 jobs as an estimate of the BD ratio. They added 14,000 jobs in the construction industry. Does anyone really think that we saw an increase in construction jobs last month? Supposedly we saw an increase of 25,000 jobs in the financial industry. The reality is that financial jobs, especially in the mortgage industry, are being shed left and right.



As I noted above, when the economy is slowing the BD ratio will overestimate the number of jobs being created. And I think the household survey is suggesting just that.

Look at the chart from Lombard Street Research below. It shows the employment surveys on a 3-month moving average. You can see that the two surveys tend to move together, except at times when the economy changes direction.



Quoting Charles Dumas (and emphasis mine): "The payroll jobs number of 1% growth [for three months] is 1% or more below its long-run average, ... If the implied GDP variance - 2-2 1/2% below trend - Lombard Street Research proves to match the past average, the GDP is growing at or slightly below 1%. The same analysis applied to the household number gives GDP growth close to zero. If either is true, these numbers are inconsistent with the results for Q2 and Q3, which ought - given that labor market data are usually lagging indicators - to have produced payroll jobs growth at well over 2%."

Employment is a lagging indicator. Typically, employment does not turn down until after a recession has already started. However, the unemployment level has already risen from 4.4% to a current 4.7%. And the household survey suggests that the rate is rising faster than in the payroll survey. As unemployment rises, consumer spending will also soften. And the Slow Motion Recession will become evident.

Round Two of the Credit Crunch

The credit crisis this summer ended up with the Fed and central banks worldwide adding massive amounts of liquidity into the system. This last two weeks have seen one bank after another make large write-downs of subprime debt on their books. Merrill found a few billion dollars more in losses than they had only a few weeks ago. My bet is that Citi will find a lot more as well.

The problem is that more and more CDOs and other forms of mortgage debts are being downgraded. It is highly doubtful that banks have written down assets in anticipation of future downgrades. As Dennis Gartman says, there is never just one cockroach. The Fed injected $42 billion into the system in the last few days. I believe that is the largest injection that has ever been made.

Take this to the bank: There are going to be more write-downs as more and more mortgages go into foreclosure, forcing more downgrades of mortgage asset-backed paper. Foreclosures are up over 200% in a number of states, and 800-900-1000% in some. Scary. Look at this list of the rise in foreclosures over the last year, from Greg Weldon (www.weldononline.com).

Arizona up + 201.7%, Arkansas up + 254.2%, Connecticut up + 920.7%, Delaware up + 389.4%, Florida up + 130.6%, Iowa up + 180.5%, Maryland up + 491.0%, Massachusetts up + 1,127.7%, Minnesota up + 124.9%, Nevada up + 212.2%, Ohio up + 136.0%, Vermont up + 400.0%, Virginia up + 516.4%, Wisconsin up +155.6%, Georgia up +84.5%, Michigan up + 78.6%, New Jersey up + 56.7%, New York up + 66.7%, North Carolina up + 99.0%, North Dakota up + 85.7%, Tennessee up + 57.3%. And on and on.

A Congressional report suggests that over 2,000,000 homes financed by subprime loans will go into foreclosure in the next 18 months. This means that more and more of the mortgage-backed assets on the books of banks, CDOs, and SIVs are going to become losses.

I think we should be getting ready for a second round of the credit crisis. And I would certainly be uncomfortable with owning any financial stock with exposure to the mortgage markets. We may not know the full exposure of many banks until the middle of next year.

The SIV Superfund is just one signal that this is serious. Last week I gave you charts that showed even AAA assets associated with recent-vintage subprime mortgages securities losing 20% of their value. That is going to bleed over into Alt-A mortgage assets, as home values drop 10 and then 15 and then 20 percent.

The asset-backed commercial paper market declined another $9 billion last week, down for the 12th straight week. It has dropped 26% since August 8, and there is no reason to think that trend will not continue for several months, as commercial paper linked to mortgage assets is simply not being rolled over. The Financial Times talks of one banker who is bartering his mortgage assets to avoid setting a price.

Bottom line? With rising unemployment, a credit crisis, and a housing bubble imploding, this is not a market or an economy where the Fed will be able to sit tight. We are going to see a Fed funds rate below 4% in two more meetings, at a minimum.

And yes, I did notice that gold went over $800 and oil almost hit $96 today. Neither are good signals. With oil jumping $2-3 up and down almost every day, the chiropractors must be doing good business with oil traders suffering from the whiplash they get almost every day.

And the dollar? It hit $1.45 on the Euro. I actually have a regulated financial entity in Canada for which I have to pay fees about this time each year, and they are of course denominated in Canadian dollars. This year the fee was 40% higher in US dollar terms than it was a few years ago. But then, my income from European-based funds is rising as well. My belief is that markets of all types are going to get ever more volatile. Stay tuned.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. Contact John at John@FrontlineThoughts.com.

Disclaimer
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.