Springtime Economy Cold Spells

Divorced from nature, human minds often make simplistic assumptions about the future. The most common one is that today's trend is tomorrow's trend. That is the kind of thinking that creates financial bubbles.

Think about the season of spring. I know that can be difficult as we enter winter in the northern hemisphere, but it is just a metaphor anyway. So think, perhaps, of last spring. It does not come on all at once, despite being driven by the steady progression of the sun to longer days. There are cycles of cold and warmth.

We may speak of winter returning, but we know as the weeks pass the snow and ice will melt and we will get more frequent warm spells. We even change our definition of warmth. In late winter a warm day may include a night time freeze. In late spring a warm day may miss freezing by 20 degrees.

Development of spring into summer is uneven across geographies. Once state may be having a late winter storm while another has a summer-like day.

So too it is with macroeconomics. We have been through a fairly severe global recession, but it is already summer in China and India. Within the American economy one sector may advance while another remains flat or even declines a bit. In particular in 2010 we saw reduced government spending, but despite that the economy did not collapse. The economy warmed up a fair amount in 2010 despite dire predictions of catastrophe in Europe and a double dip in the U.S. And despite a still-weak housing construction sector.

There are all sorts of signs that the economy is in recovery. That may not be any consolation to those frozen in an unemployed or even homeless status, but it important for investors to see the overall picture accurately. A lot of people panicked and lost a lot of their savings in 2008 when they sold stocks at the bottom of the market. If they had held on, they would be in far better shape now.

Another economic winter will come, to be sure, but we have not even hit late spring yet, much less summer. The way to prepare for winter is to lay aside your winter supplies during the summer, rather than acting as if summer will never end.

2011 should be a good year for the American economy. That does not mean it will be a good year for every single person, or for every business, or every business sector. But hopefully we have, collectively, learned something about the wise use of credit and the need to produce real goods and services in a global economy. Bidding up the prices of things that already exist, be they Beanie Babies or houses, is not a real economic advance.

Stocks can be bid up too high too, but that was not the problem during the latest bubble. Stock prices should reflect the earnings potential of the companies involved. The more profitable companies are, the higher their stock prices should be. The main danger is getting talked into investing in companies that are not profitable, or are obviously going to become unprofitable as the economy changes.

Spring is in the air. Wise investors can hear the birds singing and the wheat and corn sprouting in the fields. If you don't sow, you can't harvest. People who are 100% in bonds should be seriously thinking of rebalancing their portfolios to include stocks again. The value of low interest bonds tends to melt away during the hot days of summer. Better to own CDs at a credit union than bonds once interest rates start rising. And beware the current line of bull about investing in foreign stock funds. Many nations have even less regulation and transparency that the United States. A good rule for investing is don't do it if you don't know what you are doing. There is plenty of risk involved even when you know what you are doing.

See also: Virtuous Economic Cycle Components [September 15, 2010]

Housing Market Distortions

Most traditionalist economists believe that markets are always in equilibrium. I believe that markets are almost always out of equilibrium. The questions speculators have to answer correctly are: how much, and in which direction.

Comparing the housing market and the stock market can give a lot of insight into causes of disequilibrium. The stock market can be broken down into stocks that are heavily traded and stocks that are thinly traded. To a large extent the national housing market behaves like a heavily traded stock, but local markets trade more like thinly traded stocks.

Another useful dichotomy: is the trading auction style, or swap style? By swap style I mean the traditional markets as described by Adam Smith: a rational (or at least savvy) person at each end, trading something of value, when there is an elastic supply of the two items (one usually being money) to be traded.

Today there is an almost 10 month supply of unsold houses on the U.S. national market. Two years ago houses more often than not sold the day they were put on the market; houses under construction sold before construction began. Yet the economy is arguably stronger on the whole today that it was two years ago. Anyone who argues that the housing market, or sale prices of housing, is always at equilibrium is saying nothing. They are defining equilibrium to be whatever happens. Same for stock prices.

Suppose you are going to buy something; it could be a stock or a house. As long as the price is rising and continuing to rise it makes sense to buy as soon as possible. Maybe normally you would save up a 20% down to get a good interest rate on a mortgage; but with prices increasing, it makes more economic sense to put 5% down and pay a higher interest rate now, rather than waiting two (or ten) years to save up the down.

The same becomes true when prices are falling. Why buy house now, even if you want it and think it will be a good long term investment, if you think you can buy it for 5% or 10% less if you just wait 6 months?

Rising prices accelerate demand, which in turn makes prices rise more. That is one reason why stock prices and housing prices tend to be out of equilibrium. Falling prices tend to dampen immediate demand, which in turn causes prices to fall more. That is the other main reason prices are usually out of equilibrium. These tendencies are the basis of macroeconomic cycles and of stock market price fluctuations that may last hours, weeks or even years (or, with super-fast computerized program trades, fractions of a second).

Auction systems aggravate these trends, partly because of human psychology and partly because they create a short-term artificial scarcity or surplus. Price swings in thinly traded, illiquid stocks display this.

Buyers in the housing market aren't going to be in a hurry until prices start rising again. The exact turning point won't be obvious, partly because it will take place in different localities at different times. The willingness, and ability, of lenders to finance purchases may stall or accelerate the process of finding a bottom.

But there will be a bottom. Strangely, the longer it takes to reach it, and the deeper the retreat in prices is, the more people will think there is no bottom.