The monthly labor reports are important to understand but can be a little misleading when viewed from a single data point.

For traders that are unsure about the difference between ADP, NFP, BLS and a whole lot of other BS, this article should help. The NFP report tells us how many jobs were added or lost from the U.S. labor force. Obviously, a decline in jobs is a bad thing for the economy and a string of improving reports month after month is indicative of a recovering or growing economy.

Video Analysis: Behind the Labor Reports

This is currently the situation in the U.S. and another positive release is expected this week. Although the reports have been “improving” or at least becoming less negative over the last several months this is still one of the most important factors that could turn into a drag on the economy.

Employment gains or losses are actually reported twice each month; the official government source (BLS) releases its version on the first Friday of each month and a private analysis from ADP (an outsourced payroll processing firm) appears on the Wednesday before the first Friday.

These reports are developed from independent data sets but with a similar methodology. The reports have a very large statistical confidence interval (not very accurate) and are subject to major revisions, however the capital markets will often experience significant volatility each report date.

Advanced Data Processing (ADP), the publisher of the first report, is one of the largest outsourced payroll processing firms in the US with more than half a million clients worldwide. ADP analyzes their payroll data each month and releases a statistical estimate of the net loss or gain of jobs in the US and within specific employment categories.

The Bureau of Labor Statistics releases an identical report based on employer submitted unemployment insurance information. Because both reports are statistical samples they will never be identical. The fact that they are both statistical samples is important to understand as we seek to use the information in our investing.

A number that is supposed to reflect a large population based on a statistical sample will have confidence intervals associated with it. That means that because the statistician does not know what the actual number of jobs lost is they pick a range, within which, they are confident the real number exists.

The 90% confidence interval for the labor report from the BLS is plus or minus 430K jobs. That means that statisticians are 90% confident that the real number of jobs added or lost from the economy is somewhere within a range of 860K jobs. Although it is more likely that the real number is closer to the estimate than far away this can be a little confusing but the bottom line is that a single report does not have pin-point accuracy.

If you feel, as I do, that labor reports (among many other announcements and news events) are not very predictive on a day-to-day basis then why bother with the information at all? Most short term movements in the financial markets can almost fit the very definition of random behavior. However, the long term trend of a particular news announcement may actually be useful in ways that the individual releases themselves are not.

That means that a long term trend of lost jobs in sequential labor reports does help us predict and therefore manage a market downturn. Since the beginning of 2008 the BLS numbers were showing losses. That trend followed a year and a half of a downward sloping growth curve in new jobs added. The data becomes much more reliable when looked at over time because the total sample set is much larger.

Similarly, over the last several months in 2009 and 2010 the slope has been pointing up and fewer jobs are being lost in each report. Traders are much more concerned with where the data is headed than where it is right now.

We can use this information to manage our own investing activities. A slowing growth curve in employment and a series of negative releases helps us to know when risk control is becoming more important and why it made more sense to adjust a portfolio’s balance further towards conservative investments in 2008 than in 2010.

The long term effects on trend can be more reliable and are easily seen in equities and other “high risk” positions. In today’s video I will walk through a past ADP report as we prepare for the government version on Friday.