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Is the most recent unemployment rate too good to be true? We review the data in context to help investors interpret the headlines and assess the health of the labor market.

If we can set aside the dizzying nuances of the government’s labor statistics for a moment, it appears that unemployment is abating rather remarkably. After peaking at 10% in 2009 and remaining stubbornly elevated above 9% for the next two years, the rate has fallen abruptly to 8.2% over the last six months.

The two Presidential candidates have been quick to incorporate the news into their stump speeches. Obama cites the improvement as the latest sign the economy is recovering under his watch. Romney counters by suggesting that the President’s costly policies have been largely ineffective in moderating the historically high rate.

Given the political and economic significance of the unemployment rate, the prudent investor may benefit from momentarily distancing himself from the campaign noise for an objective review of the numerator and the denominator.

The numerator is essentially the number of people age 16 and older who are not currently working but are actively seeking work, a significant qualification we will revisit. The denominator is simply the sum of the numerator and the employed, often referred to as the total labor force.

If there are 10 unemployed individuals actively seeking work for every 100 people currently employed or looking for work, the unemployment rate is 10%. If one of the unemployed lands a job, the unemployment rate drops to 9.0%. Simple enough.

At face value a lower unemployment rate appears both easily understood and welcome news to any economy. However, pundits are raising an important question. What if the search for employment proves to be a frustrating endeavor and job seekers simply quit actively searching for work? Referencing the previous example, there would now be 9 unemployed workers and 99 people in the labor force. The new unemployment rate? 9.09%.

That’s the concern. In either scenario the unemployment rate enjoys a substantial drop. Needless to say, this presumably straightforward economic indicator warrants additional scrutiny.

Enter the labor force participation rate. This rate indicates the percentage of the working-age population (excluding early retirees, homemakers or students) who are currently employed or actively seeking work. The rate steadily increased from 59% in the mid-1960s to 66.5% in 1990 before plateauing for the better part of two decades. Since the unemployment rate peaked in 2009 though, the participation rate experienced a meaningful reduction to 63.8% in last month’s reading.

A falling participation rate indicates that an increasingly lower percentage of working-aged individuals are either employed or actively looking for work. Whereas four years ago 66.1 of 100 working-aged Americans met the criteria, today only 63.8 are included, a statistically significant reduction.

How does this affect the unemployment rate? By definition, the individuals not represented in the labor participation rate are also absent from the unemployment rate’s numerator and denominator. Thus, a lower participation rate conveniently decreases the unemployment rate without the economy having to create a single job! Had the labor participation rate held steady over the past few years, the economy would have had to create jobs for over five million additional people to support the unemployment rate being cited today.

In an election year the analysis may end there as politics has a way of clouding calculations and polarizing the conclusion. A more reasonable evaluation suggests the truth is hiding in its usual location: somewhere in the middle. While certainly a lower participation rate has served to reduce the unemployment rate, not all the improvement can be attributed to the participation rate’s influence. This suggests there has been some meaningful improvement in the most recent data, but clearly not as much as the unemployment rate alone may suggest.

This further explains why the Federal Reserve has been so strikingly hesitant to share Wall Street’s enthusiasm for the unemployment rate’s recent decline. On multiple occasions this year the Fed Chairman has reiterated the labor market’s underlying weaknesses and questioned the sustainability of recent improvements, puzzling those who accept an improving unemployment rate at face value.

In the months ahead the Federal Reserve will consider further intervention to prevent a relapse while politicians will point fingers and create sound bites. The investor we serve is again well-served with a more reserved response; setting aside isolated economic data and political spin in adhering to an unemotional and sound investment strategy.