Chuck Ponzi September 12th, 2006

First off, my apologies for the long time between posts. It has been a jam-packed month so far professionally, and I’m happy to say very enjoyable… although it does not allow me much time to blog.

While I may draw some ire from believers in the bubble blogging community with this post, I am compelled to explain why I believe we are in for a protracted slide and not an all-at-once bust.

I have heard far-fetched ideas as related to the housing bubble pop that include 6 months to a year to revert to the mean… based on human psychology, I sincerely doubt that this will occur.

The human psyche is too rooted in its ways to give way to the panic du jour. Some have compared the housing bubble to the stock bubble, while simultaneously forgetting that most stock bubbles take more than several years to unwind from top to bottom. In classical economics, this was referred to as “price stickiness”, but has evolved into a much more intense discussion with behavioural economics

Periodically, I flip to the NewYorker’s articles for some good meaty discussions, but rarely do they have much economic merit. For the most part, they are good at capturing the zeitgeist, but little more on explaining it. A great article recently came to my attention.

The writer takes us on a descriptive walk through the human’s typical response to losing money…

Like many people who have accumulated some savings, I invest in the stock market. Most of my retirement money is invested in mutual funds, but now and again I also buy individual stocks. My holdings include the oil company Royal Dutch Shell, the drug company GlaxoSmithKline, and the phone company British Telecommunication. I like to think that I picked these stocks because I can discern value where others can’t, but my record hardly backs this up. I invested in BT in 2001, shortly after the Nasdaq crashed, when the stock had already fallen substantially, only to watch it slide another fifty per cent. I should have sold out, but I held on, hoping for a rebound. Five years later, the stock is trading well below the price I paid for it, and I still own it.

The writer turns to some professionals to explain the phenomenon…

In order to depict economic decisions mathematically, economists needed to assume that human behavior is both rational and predictable. They imagined a representative human, Homo economicus, endowed with consistent preferences, stable moods, and an enviable ability to make only rational decisions. This sleight of hand yielded some theories that had genuine predictive value, but economists were obliged to exclude from their analyses many phenomena that didn’t fit the rational-actor framework, such as stock-market bubbles, drug addiction, and compulsive shopping. Economists continue to study Homo economicus, but many recognize his limitations. Over the past twenty-five years, using methods and insights borrowed from psychology, they have devised a new approach to studying decision-making: behavioral economics.

This behavioral economics was the topic of a recent response to a poster under a different heading:

realist said…
23,000 homes on the market simply shows the popularity of real esate.

Realist…
I had to read your post several times to reall see if you actually wrote that. That is one of the funniest things I’ve read by a poster. That’s a good one. I don’t often get a chuckle from posters, but that really shows how disconnected people can become from economic fundamentals.

If anything, excess inventory shows nonpreference, not high utility.

I’m surprised you’re spouting “classical economics” when you’re actually referring to neoclassical economics in your discussion of preferences and utility maximization. Smith would roll over in his grave if someone tried to pin financial manias on his economics theories!

In fact, neoclassical economics best underscores the presense of bubbles through a review of methodical individualism.

Here’s a quote from Wikipedia’s entry on neoclassical economics:
“This classic approach included the work of Adam Smith and David Ricardo. However, some economists began to say that prices for a product did not always reflect the expected value as indicated by the costs of a product. They proposed a theory that the cost of a product was not expressed in its price, but that this can be explained with differences in “utility.” Economists began to explore the way that elements such as supply and demand affected price, and neo-classical economics gradually came into being.”

One of the best theories that ever came out of the neoclassical theories of economics is one that San Diegans are about to experience: Marginalism. Essentially, that prices are determined on the margin, not solely based on aggregate demand and aggregate supply.

Behavioural Economics, an offshoot of Neoclassical economics best describes the type of manias that evolve through expected and discounted utility.

Again from Wikipedia:
Cognitive biases have real anomalous effects only if there is a social contamination with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology as on individual psychology.

I recommend people move out of Southern California if they are not happy with current housing prices. Many people are disastrously overleveraged, and will live the worst kind of life to stay and avoid a loss; if you want a better life, you may have to compete with them for jobs, housing, and everything else. Ever tried to use logic to bet against someone who has nothing to lose? Hint: they don’t bluff too easily when they have nothing to lose with an increased bet and an escalated level of commitment.

From Wikipedia:

Escalation of commitment is the phenomenon where people increase their investment in a decision despite new evidence suggesting that the decision was probably wrong. Such investment may include money (known informally as “throwing good money after bad”), time, or — in the case of military strategy — human lives. The term is also used to describe poor decision-making in business, government, information systems in general, software project management in particular, politics, and gambling …

Irrational escalation (sometimes referred to as Irrational escalation of commitment) is a term frequently used in psychology, philosophy, economics, and game theory to refer to a situation in which people can make irrational decisions based upon rational decisions in the past or to justify actions already taken. Examples are frequently seen when parties engage in a bidding war; the bidders can end up paying much more than the object is worth to justify the initial expenses associated with bidding (such as research), as well as as part of a competitive instinct.

We may soon find that sellers are even more stubborn on prices, and buyers even more stubborn themselves to “end this protracted standoff”. On the seller’s side because of ego, on the buyers’ side because of the inability to finance the price. Real estate professionals that are hoping for a quick resolution to the high inventory levels, may find that working them off quickly with an even lower volume of transactions won’t happen.

This is how seemingly benign “slowdowns” can turn into protracted panics. Noone wants to use the exits until everyone else is already there.

The much-written about mean reversion of incomes and rental ratios to housing costs will happen, the only question how long will it take. In my “Soft Landing, Depends on What You Consider Soft” post in April last year, I outlined a “soft landing” scenario (a term actually coined by Leslie Appleton-Young who interestingly enough no longer feels comfortable using that phrase and now publicly wishes she had not uttered it). If you believe in a 22 year less-than-inflation soft landing, I am confident that you will find that there are better investments than housing, even with the advantage of leverage. If you believe in something more accelerated, hold onto your boots, it might be a bumpy landing.

My advice?
Do what makes sense for you, but don’t worry about living your life based on the price of a home. As I said before, California is not the land of the promised, and yes, I believe that there are still areas in America that would not be considered a bubble. With the increasing portability of jobs, companies may find that near-shoring of jobs through allowing employees to work remotely is cheaper than they had previously thought.

Some time ago, I grabbed a quote from a fellow blogger, only to leave it packed on my back shelf waiting for the appropriate time to use it. The source of this quote is here. The poster of this quote is Robert Coté

California affords opportunities that transcend class and socioeconomics barriers.
There is no nation on earth as balanced and blessed as is the nation-state of California.
Everyplace else is enhanced by association with California, diminished by its absence.
California retains the ability to reinvent itself, does not take itself too seriously, and is not afraid.
People continue to flood in at the bottom and trickle out at the top to spread the story.
Optimism, while not the exclusive provenance of California is guiding principle.
Leadership brings criticism. Pioneers suffer more than those who follow. California continues to worry about the future prefering that to dwelling on the past. A big gangly adolescent, there is much for the state to learn the hard way but much promise as well.

Don’t ever bet against California. Short the near term sure but go long.

I would like to remind readers that California holds a special spot in my heart, but that it is not the center of the universe. While Robert describes the California of the previous 25 years, it seems that it does not describe the California of today… opportunities are only as good as the backdrop they are in front of. Because of this, California’s opportunities do not look so great right now.

Finally, my apologies for the rushed nature of this post, and my lack of recent posts… I will be contributing more, so please check back on a regular basis to see if anything new has poppsed up!

• Uncategorized
• Comments(25)