With the economy recovering, the market doing well, and the politicians seemingly getting down to the business of actually negotiating rather than yelling at one another, people are feeling more cheerful, especially about the stock market. Investor surveys are at very high levels for confidence, volatility is at historically low levels, and U.S. markets are closing in on all-time highs. What’s not to like?

Actually, there are a lot of reasons to be concerned—which I have written about in the past and will do so in the future—including the fact that high levels of bullishness are themselves contrary indicators. Today, however, is about how to invest in individual stocks, rather than about the market as a whole, and here there are encouraging signs.

When I saw the above headline in today’s New York Times (page A3), I have to admit I was taken aback. All of the discussions I have heard about nuclear war recently have been metaphorical, typically centering on how Congress is dealing with something. This one isn’t. Reading the article is scarily reminiscent of civil defense drills that I am just old enough to remember—when we stood in the central hallway of the school, facing the wall with our hands over our heads.

I couldn’t have asked for a better reminder that even as economic risks recede—and they are receding—there are a number of geopolitical risks that will come back to fill that worry-space. The relationship between India and Pakistan is certainly one risk; another is Japan and China, where, as of yesterday, both countries were sending fighter jets to the disputed Senkaku/Daioyu islands.

I hope everyone enjoyed the long weekend as much as I did. My son, Jackson, and I built a small working wooden catapult and a fire-dog house using his cardboard blocks. And he went skating and to a SteveSongs concert with his mom.

A popular talking point these days is that the deficit over the past several years has been the worst since World War II. That’s absolutely true, as you can see from the chart below, but the statement misses a key point.

China has been in the news quite a bit recently, and it is past time to take another look at what is going on in the second-largest economy on the planet, especially since it is one of the keys to global growth going forward. China matters, as everyone knows, but it may matter for different reasons going forward than it has to date.

One of my favorite authors is Terry Pratchett, best known for a series of novels about the Discworld, a fantasy world (very) loosely based on medieval London and Europe. When you hear “fantasy,” though, don’t think unicorns and rainbows; instead, think folklore and Charles Dickens. Pratchett’s writing is an interesting combination of Dickens and Douglas Adams (The Hitchhiker’s Guide to the Galaxy), with more than a bit of P. G. Wodehouse thrown in. The series is worth a look, but the later books are better than his earlier ones, in my opinion.

One of the tropes of Pratchett’s universe is “narrative causality,” the notion that stories are entities that actually shape behavior in the real world. As he writes in The Last Continent, “. . . the proliferation of luminous fungi or iridescent crystals in deep caves where the torchlessly improvident hero needs to see is one of the most obvious intrusions of narrative causality into the physical universe.” Obviously, narrative causality doesn’t extend into the physical universe here, but it does extend into the behavioral universe. Therefore, it’s worth considering in terms of economics, which, after all, is just human behavior writ large.

Following on the review of how well the housing market is doing, I thought I would take a look at employment.

As I’ve been talking about the housing recovery for some time, I thought it would be worth giving it a more detailed look. I don’t intend to get very quantitative here, but there are a number of charts that illustrate just how far we’ve come. First, let’s take a look at housing affordability.

One of the wonderful things about the digital age is the emergence of mash-ups, where people combine elements of existing art in new ways. The idea has been around for decades, of course, but the Internet and digital technology have made it even easier to create and distribute.

Looked at in financial terms, the Federal Reserve (Fed) has done its bit by expanding the monetary base. There is quite a bit of money ready to go, and when it gets put into the economy, we will see inflation. But first, we need consumers and business to borrow and spend that money. That hasn’t happened yet; when it does, then we’ll need to worry about inflation. So it gives us a list of things to watch for:

1. The unemployment rate decreases. As excess labor is absorbed, companies will be forced to raise wages, which in turn will increase spending power. This is a necessary condition for inflation to move significantly higher, barring a rise in input costs, such as an oil shock. This will also signal increased growth, which should lead businesses to start investing again.
2. Banks start lending/consumers start borrowing again. This will probably lag increased employment, as people won’t/can’t, borrow without jobs, but once employment recovers, borrowing will most likely be close behind.
3. Growth in gross domestic product (GDP) ticks up. This will be an inevitable consequence of 1 and 2, but it is still worth watching as a leading indicator. Growth absorbs labor, materials, and everything else, and by increasing demand, it will certainly stoke inflation.

Even when some or all of these occur, inflation will not necessarily be on the immediate horizon, as there is still quite a bit of slack to work through—but it will be getting close. At that point, we should also see bond yields start to increase, which brings us to the investment implications.

Because we know inflation will increase eventually, any investments intended for more than a year or so should bear that in mind. For fixed income, shorter durations both limit the price risk and provide the opportunity to reinvest sooner at potentially higher rates. For equities, buying stocks that may potentially respond favorably to inflation, such as real estate investment trusts or commodity stocks, might make sense. For people who own or plan to buy homes, it would make sense to lock in today’s low rates.

None of this is to say that inflation is imminent—it is not. At some point, though, growth will resume, and the excess capacity that we presently have will be used up. As I have said, I believe that the U.S. economy has started a sustainable recovery, and if it is not derailed by actions from Washington, DC, that recovery may well result in inflation sooner than anyone now thinks. If so, that will actually be a very positive outcome, as it will mean we are finally through the aftermath of the financial crisis and into a more normal world.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs, and international economic, political, and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Real estate investments are subject to a high degree of risk because of general economic or local market conditions; changes in supply or demand; competing properties in an area; changes in interest rates; and changes in tax, real estate, environmental, or zoning laws and regulations. REIT units/shares fluctuate in value and may be redeemed for more or less than the original amount invested.