Irrational on the Way Up, Rational on the Way Down?

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I’m continually amazed on how otherwise intelligent people fail to learn the lessons of history. Whenever an asset class gets into an inflated bubble, the bubble does top out and the blowback is a bitch. Prices do not settle to fair market. They overshoot. Home prices will not settle gracefully to fair market values. They will go lower.

Here is why. The normal way to buy a home is to first save up enough money for a down payment. During the bubble years, homes were appreciating at a faster rate than one could save money. Lenders then lowered the standards and this pushed values even higher. They threw gasoline on the fire. Anyone that sat on the sidelines was punished for missing out on the appreciation. Credit was king and cash was trash.

Now we are seeing the opposite. Home prices are now depreciating at a faster rate than one can build savings. So every month that passes by, the saver is able to afford a better home. Ironically, being a renter and staying out of the market is now the fastest way to build (future) home equity. Credit is drying up and soon cash will be king.

One of my financial mentors Karl Denninger wrote this today:

What this means for you is that if you think home prices will “bottom” in the next six to nine months you are sadly mistaken and are about to get a very expensive and nasty lesson in the reality of economics.

In addition we are likely to see an overshoot in prices – perhaps by 1/4 to 1/2 of the “height” of the bubble. If so, that would take inflation-adjusted home prices down to around $100,000, which is a decline of another fifty to sixty percent – not 30% – from today’s prices.

In a normal market, the future home buyer can pull out a calculator to determine when it is time to buy a house. When an asset bubble collapses, one also needs to figure out the market sentiment. Look at the chart below.

Back in March, I listed 4 rules for Picking a Real Estate Bottom. I would add market sentiment as a loose 5th rule. Be aware of it. Listen. Save money and be patient. That million dollar condo with the view won’t be a million at the bottom.

6 thoughts on “Irrational on the Way Up, Rational on the Way Down?

  1. aviva

    once again…not really too sad that we’re waiting out this bursting bubble in japan for a few years. I also think that the market isn’t the same in all cities – there are places where it didn’t inflate as badly (obviously SD was extreme). when we return we’ll likely be on the east coast – and ready to buy ocean-front property since we’ll be able to afford it.

  2. Jim

    The emotion chart should play out as follows …when you tell people you are planning to buy real estate and they laugh at you …that is the time to buy.

    Be careful applying it to stocks in a bear market though. I think that chart plays out about 5-10 times from the peak to the final trough.

    Finally, to add some historical context for over shooting to the downside, Shiller showed a housing price index for the UK in one of his recent papers. The UK is amazingly working through their third housing bubble in recent times (this one a monster). The previous two bubbles overshot after they hit the mean …dropping another 20-30%. This makes perfect sense if you think about it though …it’s the mean because prices are below this line HALF of the time.

  3. Jim – Excellent point on applying that chart to the stock market. On a week to week basis it does seem to cycle from point to point.

  4. I’m keeping my fingers crossed that I bought in a fairly stable market (Albuquerque, near the University) housing is always at a premium due to demand. At the very least– I hope– I won’t be losing money, nor throwing a rental payment towards building someone else’s equity.
    Of course I won’t get rich in real estate….
    but I won’t be upside down either 🙂

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