I’ve mentioned before how all of my old articles at RealMoney were lost. This was the draft version of Real Estate’s Top Looms published on 05/20/05. I followed it up with Housing Bubblettes, Redux on 10/27/05 and September 2005 — The Residential Real Estate Inflection Point on 02/14/06. Also, there was Wrecking Ball Looms for Big Housing Spec on 11/27/06, where I explained why it was likely that the subprime residential mortgage market was likely to blow up (can’t find the draft of that one).
But those links above no longer work — a real pity, and the one link below is corrected to point to the republished article at my blog. Anyway, enjoy this if you want, because it outlines my thinking on how to recognize whether you are getting near the end of the bull phase of a market.
(Note: the italicized, indented portions, quote the original article The Fundamentals of Market Tops. Much of what I write compares how residential real estate is similar to and different from stocks.)
About a year and a half ago, I wrote a piece called The Fundamentals of Market Tops. It was an important piece for me because I received a lot of positive feedback from readers. It was also important because it disagreed with the view of the firm that I worked for, and nearly led to my termination there, because they encouraged me to stop writing for RealMoney. Neither termination happened, but it was touch-and-go for a while.
This piece unofficially represents the views of the firm that I work for, because my views of macroeconomics have become the firm’s views, but I don’t directly control our investment actions. What I will try to accomplish here is to try to apply the logic of my prior article to the residential real estate market. As opposed to my earlier article, I will try to show why I think we are close to a market top in residential real estate. There is reason for pessimism.
The Investor Base Becomes Momentum-Driven
Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
This is what I see in many residential real estate markets now: panicked buyers are saying “this is my last chance,” and buying houses using risky forms of financing. At the same time, I read stories of despair as some potential buyers give up and say that a house is out of their reach for now; they waited too long. Occasionally, I see a few articles or e-mails regarding people who seem to be bright selling their homes and renting, but this is a minority behavior.
In the face of this, residential real estate prices continue to rise, particularly in the hot coastal markets, which tells me that the price momentum can continue a little while longer until it fails because there is no incremental liquidity available to expand the bubbles.
You’ll know a market top is probably coming when:
The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.
Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.
Valuation-sensitive investors who aren’t total-return driven because of a need to justify fees to outside investors accumulate cash. Warren Buffett is an example of this. When Buffett said that he “didn’t get tech,” he did not mean that he didn’t understand technology; he just couldn’t understand how technology companies would earn returns on equity justifying the capital employed on a sustainable basis.
The recent past performance of growth managers tends to beat that of value managers. (I am using the terms growth and value in a classic sense here. Growth managers attempt to ascertain the future prospects of firms with little focus on valuation. Value managers attempt to calculate the value of a firm with less credit for future prospects.) In short, the future prospects of firms become the dominant means of setting market prices.
Momentum strategies are self-reinforcing due to an abundance of momentum investors. Once momentum strategies become dominant in a market, the market behaves differently. Actual price volatility increases. Trends tend to maintain themselves over longer periods. Selloffs tend to be short and sharp.
Markets driven by momentum favor inexperienced investors. My favorite way that this plays out is on CNBC. I gauge the age, experience and reasoning of the pundits. Near market tops, the pundits tend to be younger, newer and less rigorous. Experienced investors tend to have a greater regard for risk control, and believe in mean-reversion to a degree. Inexperienced investors tend to follow trends. They like to buy stocks that look like they are succeeding and sell those that look like they are failing.
Defined benefit pension plans tend to be net sellers of stock. This happens as they rebalance their funds to their target weights.
Houses aren’t like stocks for several reasons:
- Unlike stocks, houses are used by their owners every day.
- We can short stocks, but we can’t short houses. (Personally, I hope no one comes up with a clever way to do so. We have enough volatility already.) The most someone can do is sell his home and rent.
- Perhaps the equivalent of a long-only manager is someone who owns his property debt-free, like me, and doesn’t see the need to lever up by moving up to a larger home. Measured against the standard of “what might have been” is a terrifying taskmaster from an investment standpoint. I avoid it in equity investing, and in home ownership.
- I am aware of a number of people (I have been assured that they are not mentally incompetent) who have sold their homes and started renting. This to me is the equivalent of going totally flat in equities, or other risky assets. Not that one faces negative carry, because the ratio of rent to in the hot markets is pretty low. In many markets, you can earn more off the proceeds than you pay in rent (leaving tax consequences aside). This leaves aside the issue of appreciation/depreciation of housing values, but when one can rent more cheaply than buying, it is a negative for the housing market.
- My point about momentum strategies is definitely pertinent here. With the existence of contract-flipping, a high level of amateur investment (seemingly under the guise of “buy what you know”), and a high level of investor interest (10%+), there is a lot of momentum in real estate investment. People buy because prices are going up. Some buy because it is “the last train out,” and they have to jump rather than be stranded. Nonetheless, momentum tends to maintain in the short run, and the slowdown posited last fall definitely has not occurred.
- Value vs. Growth does not