It’s becoming clear that institutional investors are expecting big things from the economy over the next two years based on their expectations of stock market performance.

Earlier this month, Citigroup analysts surveyed a group of 81 small- and mid-cap investors and found that the bulls outnumber the bears by a wide margin: 88% are looking for gains beyond 3% this year and none expect losses in excess of 10%.

Furthermore, just 6% believe we will see new market lows in 2010 versus 60% who believe that the March low was the bottom for this cycle.

The takeaway here is that a large number of pros believe the recovery trade is underway and that it will mostly be smooth sailing ahead.

Green Shoots Wither Under Scrutiny

Now, I want to share with you some observations from Gluskin Sheff economist David Rosenberg on why these dreamy expectations are losing touch with reality.

We received a lot of what appeared to be positive economic news in the past week — playing into the green shoot hypothesis perfectly.

Under closer inspection, these data points lose some shine. 

For example, take the 148,000 person decline, to 6.69 million, of the number of folks making continuing unemployment claims. Initially, this sounded like great news as people found work and no longer needed the government’s assistance. In reality, it is more likely that people are beginning to exhaust their benefits as the time spent out of work continues to grow. Some 2.6 million people are getting extended or emergency benefits. These don’t last forever. 

Another green shoot that withers under scrutiny is the Conference Board’s index of 10 leading economic indicators. The index rose 1.2% in May to an eight-month high of 100.2, adding to a one-point gain in April. Unfortunately, nearly 60% of the increase was the result of financial variables: the stock market, money supply, the yield curve. The other 40% percent came from survey data including consumer expectations. If we propose that consumer and investor expectations are overly optimistic, then all we are left with is the Fed’s manipulations of the money supply and interest rates. 

True economic variables like building permits, hours worked, goods orders and jobless claims all continue to move lower. Not good.

Job-Market Optimism May Be Premature

Jobs are the bedrock of the economy. People who work buy things, and that allows manufacturers the opportunity to make things, retailers to sell things and banks to finance things. 

Lately, the employment news has seemed to improve just a little, or at least stop getting worse. And I’ve noted that when companies slash head count, the drop in expense helps them earn more. Both of these have qualified as green shoots.

But after perusing some new data this past weekend, in addition to the Rosenberg study mentioned above, it’s beginning to look increasingly like job-market optimism may be premature.

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The San Francisco Federal Reserve Bank published a study this month with the headline, "Jobless Recovery Redux? Reasons for Pessimism." Here’s a look at what they say, with a big assist from my favorite labor market analysts, Philippa Dunne and Doug Henwood. 

Reasons for Pessimism

The SF Fed looked at three labor market indicators — flows in and out of unemployment, involuntary part-time employment and temporary layoffs — to project how the unemployment rate might behave when the anticipated recovery begins.

They point out that before the 1991 recession, increases in the inflow rate, the speed at which workers move into unemployment, and decreases in the outflow rate, the pace at which they find jobs, were nearly equivalent in relative terms during recessions. Sharp increases in the unemployment rate were followed by rapid recoveries as firms hired back workers in improved conditions.

Increases in the unemployment rate in the 1991 and 2001 recessions, however, were driven by disproportionate declines in the outflow rate, making lack of hiring the primary culprit. And recoveries diverged from the established pattern as well: outflow rates recovered much more slowly than they had in pre-1990 recoveries. In fact, the authors cite several studies showing that current business-cycle fluctuations in the unemployment rate are driven primarily by the outflow rate.

The current recession is particularly nasty because the outflow rate is at an historic low and the inflow rate is rising in line with the recessions of the 1970s and 1980s. That’s a worst-case scenario and has made the current condition too painful to many of our friends and neighbors.

What Does All of This Mean? 3 Possible Outcomes

The SF Fed goes on to evaluate several possibilities for the future.

• Their benchmark, which was no change in the outflow/inflow rates, would bring the United States to 10% unemployment by 2010.
• The optimistic consensus included in the paper proposes an employment recovery slightly weaker than that of 1983 and a bit stronger than that of 1992, bringing the unemployment rate to a peak of 10% in early 2010, followed by a decline.
• But if inflow/outflow rates behave as they did in 1992, unemployment would peak at 11% by summer of 2010, and remain above 9% through 2011.

According to the paper, that’s where temporary layoffs and involuntary part-time work come in. In the current recession, those involuntarily working part-time have risen dramatically to an historical high, from 3.0% in December 2007 to 5.8% in April 2009, with significant reductions in hours across broad sectors. 

At the same time, the share of workers on temporary (vs. permanent) layoff is very low. In fact, it actually fell from 12.9% in December 2007 to 11.9% in April 2009. (Generally the share of workers on temporary layoffs rises during recessions.) So with few workers on temporary lay-off waiting in the wings, and a large number working part-time against their will, it seems logical that employers will expand the hours of partially idled workers instead of taking on new employees.

You see where this is going, right?

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The authors chop all this together with some regression analysis and figure labor market slack will be higher by the end of this year than at any time since 1945; the outflow rate will be historically low; and the unemployment rate will be sticky. In other words, any recovery that does occur over the next year will likely be jobless and joyless.

One more thing on employment: The first Friday of every month we get the national stats. But there are also job stats published later in the month that breaks down employment by state, which sometimes give a different picture than the national view.

According to Dunne and Henwood data, 36 states reported statistically significant increases in unemployment in May, and there were no significant decreases — a deterioration from the April reports.

To give you an idea, in April eight states reported unemployment over 10%; now the number is 14. The worst are 14% in Michigan, 12.4% in Oregon, 12% in Rhode Island and South Carolina, 11.5% in California and 10.2% in Florida.

As a result of lower tax receipts from falling employment, the Rockefeller Institute reports that states are expected to make more cuts in social services at this already difficult juncture.

For a couple of months I have encouraged investors to be a bit more optimistic than the consensus because the Economic Cycle Research Institute’s Weekly Leading Index, which has historically been quite accurate at forecasting business cycle upswings, has been dramatically improving. And as you can see in the latest chart above, published earlier this month, that is still the case.

Let’s hope that the ECRI is right again, and that worsening employment trends, while painful to the jobless and their families, does not derail any budding recovery that might really be under way.

In the meantime, continue to treat all rallies as trades.

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