There’s a problem with good news: it tends to be boring. No wonder the evening news features images of houses burning down; watching houses being built is only slightly more exciting than watching grass grow. A major principle of behavioral finance reinforces that bias. According to “prospect theory,” and confirmed in numerous experiments and real-life investing mistakes, we feel the pain of loss more intently than we feel the pleasure of an equivalent gain.
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So if my goal is to keep as many of you reading as possible, which of course it is, I’ll tend to write about how the economy and financial markets are in bad shape and poised to get worse. If I start describing how things are improving, you’re likely to click the return button and look at the weather report. In one of my talking-head stints on business TV a while back, the anchor actually cut off my segment when I suggested there might be good news about the economy in a modest uptick in interest rates. “We’ll talk about good news some other time,” I recall her saying.
Bad economic news hasn’t been hard to find for the past five or six years. Many economies, especially in the U.S. and Western Europe, have been suffering from the lingering aftereffects of a major, debt-fueled asset bubble. The economically and financially depressing effects of such a bubble bursting take years—on average about seven—to dissipate. Like the biblical seven lean years, a bursting bubble can badly punish those who don’t treat it with considerable caution. But unlike the Pharaoh’s wheat crop, the unwinding of an asset bubble doesn’t show up as a bumper harvest in the eighth year; its effects fade and results gradually improve.
Take one of the victims of the 2007-2008 financial crash, the household balance sheet—the balance between what we own and what we owe. The ratio of U.S. household liquid assets to liabilities fell to a bit more than 1.5 times in October of 2008 (it had reached twice that level at the height of the dot-com bubble), but has recently returned to its 30-year average with liquid assets more than double household debt. In mid-2007, household debt reached 130 percent of disposable personal income almost 1.7 times its 30-year average of 76.5 percent. Currently that measure of the household debt burden stands at 107 percent and may not fall much further since, thanks to extremely low interest rates, the average cost of servicing that debt is at a 31-year low.
At once a cause and an effect of improving household balance sheets is an improving housing market. According the S&P/Case-Shiller 20-city composite index, U.S. home prices rose 5.5 percent during the 12 months ended November 30, 2012, setting 2012 up to be the first year of significant house price appreciation since 2005 (2006 showed a barely noticeable increase). Slowly rising home prices have several implications. In June of 2008 nearly a third of home mortgage balances exceed the home’s value; as of September 30, 2012 “only” 28.2 percent of mortgages were underwater—not great but considerably better. A bit of home equity might make a homeowner eligible for a bit of credit and, more importantly, it erases the feeling that I’m waking up every day poorer than the day before. If I need to sell my house to take a job somewhere else, I can do it without a bank agreeing to a short sale.
Feeling a little wealthier also means we might risk a major purchase we've been putting off. In December 2012 Americans bought 15.4 million cars at a seasonally adjusted annual rate, down from 20.7 million in July 2005, but up significantly from 9 million in February 2009 at the nadir of the Great Recession. Retail sales, in general, improved in 2012 and even appear to have held up in January of 2013, despite a payroll tax increase that affected almost everyone’s paycheck.
Our willingness to buy a few things seems to influence what businesses spend as well. Tracked over many years, businesses’ investment in plant, equipment and software shows a tight relationship with their cash flow. No surprise here, businesses tend to expand when the cash register is filling up and hold off investing when cash is scarce. The ratio of corporate cash flow to non-residential investment hovered around 80 percent from the late 1940s right up to the point when the bursting bubble threatened to take down the financial system. The ratio breached its long-term average—meaning that businesses were holding more cash relative to their investments—in September of 2008 and kept growing to almost 140 percent in March of 2010. But from that peak, the relationship has moved back toward its long-term average. Businesses are still generating cash, but more of that cash is finding its way back out from under the corporate mattress and back into growing the business. If history is a guide, there’s fuel for more growth.
While the news focuses on our fiscal challenges, employment lags, and political confrontations, the U.S. economy, like a house boringly under construction, is quietly laying the foundation and raising the frame of an expanding structure. That combination is constructive for investors, at least until the next time good news actually becomes popular again. When we've all gotten excited about the easy money to be made in flipping dot-com stocks or golf-course condos, we’ll only hear the good news. That’s the time to worry. If no one is telling you how bad things are, sell.
Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.