Tuesday, October 21, 2008

Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble.

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:
  1. a significant and long-term decline in household formation.
  2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
  3. an increase in adult children living in their parents home (including after marriage or cohabitation).
  4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
  5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
  6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
  7. a decline in both household income or the expected growth rate of household income.
  8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
  9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
  10. a substantial expected increase in real estate taxes.
  11. other possibilities that affect the economic value of a home that I have not mentioned.
Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.

Friday, October 17, 2008

Markets Are Efficient But Can Be Wrong

Markets are efficient and the press and the other media often ignore or misstate the concept's meaning and ideas.

A market is efficient if past prices cannot be used to predict future prices. The period to period change in the prices of actively traded assets such as stocks is random and it is this randomness that makes stock efficient.

In an efficient market, as in all other random markets, the best basis for predicting tomorrow's price is today's price plus a gain for the risk of buying the stock. Likewise, the price of the asset traded in an efficient market already reflects the effects of any information that is available whether through announcement, deduction, logic or expectation. Numerous studies over the past fifty years have upheld the efficiency of actively traded markets.

So any statement about the future movement of a stock's price based on its previous stock price movement is hogwash no matter the terminology used such as top, bottom, stochastic, candlestick, capitulation, and many others. Likewise, any statement that a stock price does not reflect announced information or that it will take several days for the stock price to reflect the news is also hogwash.

The concept of efficient markets does not mean that a market's prediction about a stock's price is always correct. The price in an efficient market is the market's best guess based on all knowable information. The market can guess wrong. Just as in any prediction about future events that have not taken place yet, a guess can be wrong or unexpected events can happen. In an efficient market, the price of a stock is fair in that it is just as likely to be too high as it is too low and no historical information about past stock prices or past events can give an investor an edge over a naïve investor who just buys and holds.