Housing Market Bottom - Price Action Estimates

By Author: Lawrence Roberts
Total Articles: 4762
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Most market participants focus on price action. The price-to-price feedback mechanism largely responsible for bubble market behavior gathers its strength from an awareness of market pricing, and the widespread belief that short-term, past price performance is predictive of long-term, future price performance. It is a fallacy that is often reinforced in the short-term as irrational exuberance takes over in a market, but over the long term, short-term price movements rarely correspond to long-term price trends, and when they do, it is only by chance.

Predicting future prices based on price action is based on the premise that long-term price trends are reflective of fundamental valuations because they represent the collective wisdom of the market. As with all methods of predicting pricing, deviations from the long-term fundamental valuation almost always result in a return to this value. The weakness in this theory is in its failure to provide a causal mechanism. To note that prices return to long-term valuations without postulating why prices do this provides no mechanism for estimating when prices will return to fundamental ...
... value, and it provides no way to determine if there is a significant change to the market’s valuation to establish whether or not prices will return at all. In short, past price action itself is very limited in its ability to predict future price action. Despite the shortcomings of the methodology, predictions based on past price performance are widely used and often woefully inaccurate.

From 1984 through 1998, national house prices appreciated at a rate of 4.5%. There is a strong correlation between this rate of price increase and observed market prices. There is only one deviation from this rate of appreciation during the period. The effect of the coastal bubble of the late 1980s on national prices creates a small rise from the historic appreciation rate and a sideways drift of prices until values resume their 4.5% annual rise. Since prices consistently match this rate of appreciation, and since prices deviate once from this rate in a prior price bubble and return to it, there is a compelling argument that prices will drop to this level of long-term appreciation and begin rising again. If this proves to be true, national home prices will decline 10% from the peak, bottom in 2009, and return to the peak by 2011. This is the market’s best-case scenario.

The story for the most inflated markets such as Irvine, California, is much the same as the national forecast. If the 4.4% rate of appreciation seen from 1984-1998 is repeated, then prices will decline 45% from the peak, bottom in 2011 and return to the peak in 2023. Since prices peaked in 2006, this method of price projection shows an 18 year peak-to-peak waiting time: not a comforting forecast for Irvine homeowners.

The key assumption in this analysis is that market prices will resume the rate of appreciation seen from 1984 to 1998. This rate of house price appreciation is 1.4% above the rate of inflation, 1.2% above the rate of wage growth, and 0.7% above the very long-term rate of house price appreciation. House appreciation cannot exceed wage growth forever: trees cannot grow to the sky. People have to earn money to buy a home (unless of course we become a nation of the landed gentry in which real estate is only transferred through inheritance).

House prices outpaced wage growth for two reasons: first, debt-to-income ratios rose as people put higher percentages of their income toward making payments; second, interest rates declined allowing people to finance larger sums with less money. Much of the reason house prices appreciated at a rate in excess of its normal relationship to inflation is due to the gradual decline of interest rates during the period. As interest rates decline, the amount people can borrow increases. If people can borrow more, they can bid prices higher. House prices appreciated at a rate greater than its long-term average due to declining interest rates. If interest rates stop declining (which is likely), or if interest rates begin a cycle of long-term incline, the rate of house price appreciation will be impacted negatively; the drop of prices from the deflating bubble will be deeper, and the date of ultimate price recovery will be much later.

The median sales price measures the general price levels at which buyers are active in the market, but it does not reflect the quality of what is purchased and it does not reflect the price changes of individual properties. The S