Rosy Jobs Rate Has Thorny Underside

Friday's nonfarm payroll number was -- once again -- below consensus. Yet despite that disappointment, some fund managers and market watchers took solace in the newly lower unemployment rate.

They shouldn't have. If you drill beneath the headline number, you will see that the data is much less rosy than implied by the headline number. The reality is that the jobs situation is far more discouraging than it appears to be.

The Source of the Confusion

Ask the average investor (or the average economist for that matter) and they will tell you unemployment is going lower because more people have gotten jobs. Turns out, that's not the case.

In mid-2002, unemployment peaked at about 6.3%. In Friday's report, it had fallen to 5.2%. It's long been believed that a 6% unemployment rate represents full employment. How can this be anything but good news? Well, when you consider exactly how the unemployment rate is calculated, you can see why there is cause for concern.

The unemployment rate is the complementary number to the national employment rate -- the two of them must add up to 100%. The employment rate is calculated by dividing the number of people employed full time in nonfarm jobs (as defined by BLS), and dividing that by the total labor pool (the math is pretty simple).

Unfortunately, too many investors stop their research after seeing the headline unemployment number. As I have mentioned previously, headlines can often be deceiving. What many investors tend to overlook is that the labor pool has also been decreasing since mid-2002. This has occurred despite a continually rising total U.S. population. That's a rather curious phenomenon.

The math here is simple. Any percentage is just a fraction with 100 understood as the denominator. The unemployment rate is 100 minus the employment rate percentage (workers/labor pool).

Thus, there are only two ways to make the employment percentage bigger: make the numerator bigger (i.e., more people getting jobs) or make the denominator smaller (i.e., less people in the labor force).

Thus, the unemployment percentage has been decreasing not because more people are getting jobs, but because the labor pool keeps shrinking.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].