A great many people like it when houses go up in price. During a rally the bulls become intoxicated with greed and obsessed with owning real estate as an investment. However, once houses become an investment, the prices of houses begin to behave like an investment, and volatility is introduced into the system. You do not want houses to trade with the volatility of a commodities market. It causes more harm than good.
Price volatility is a very disruptive feature in a housing market: the upswings are euphoric, and the downswings are devastating — and there are downswings. Declining house prices are emotionally and financially draining both to individuals and to the economy as a whole. The upswings create massive amounts of unsustainable borrowing and spending, and the downswings create economic contraction, foreclosures and personal bankruptcy. Is the ecstasy of the rally worth the despair of a crash? I think not, but we shall see.
There are technical reasons for a market crash (foreclosures, credit tightening, etc.) and I have discussed those in great detail in earlier analysis posts; however, market psychology plays a large roll in how and why it all plays out. The technical factors cause shifts in psychology among the market participants which exacerbate market moves. Today I will examine the psychology of market bubbles drawing parallels between the commodity futures market and the real estate market. In this post want to clearly illustrate how and why the psychology of market participants will facilitate the ongoing price crash.
In a commodities or securities market, you simply cannot have a rally, unsupported by valuation measures, without a crash back to fundamental value. It is very clear the rally in house prices was not caused by a rally in the fundamental valuation measures of rent or income. This was documented in How Inflated are House Prices? and The Anatomy of a Credit Bubble. Many people forgot the primary purpose of a house is to provide shelter — something which can be obtained without ownership by renting. Ownership ceased to be about providing shelter and instead became a way to access one of the worlds largest and most highly leveraged commodity markets: residential real estate.
Trading is a very difficult endeavor. The vast majority of active traders lose money, and most don't last very long. I paid my dues to the market, but I am one of the survivors. In the process, I spent many, many hours looking at charts and watching the chaotic gyrations of market prices in real time. I have also become keenly aware of my own emotional reactions and those of other market participants. It was these experiences, more than anything else, that kept me from participating in the real estate bubble. I have learned (painfully at times) that traders who "chase the market" lose money. I was not going to chase the real estate market.
The Psychology of the Bubble
The above graph is an excellent depiction of the psychological stages of a market bubble. It is fairly easy to put timeframes to each of these stages as displayed by our local housing market:
- Take off: 1998-1999
- First Sell Off: 2000
- Media Attention: 2001-2002
- Enthusiasm: 2003
- Greed: 2004-2005
- Delusion: 2006
- Denial: 2007
- Fear: 2008
- Capitulation: 2009-2010
- Despair: 2011-2013
- Return to the Mean: 2014
Obviously, the past is easier to document than the future, so we may reach future stages sooner or later than shown above, but we will reach them. I have made my opinions on timing and depth of the decline known in Predictions for the Irvine Housing Market.
The Stages of Grief
Markets are the collective actions of individuals, and the psychology of the markets can be broken down to the psychology of the individual participants who make it up.
When prices first drop and the market enters the denial stage, the individual market participants feel confusion and attempt to avoid the truth. This is motivated by fear they may have been wrong to purchase when they did, and they might lose money. They seek ways to quell these fears through drinking even more kool aid. Bulls in the denial stage will not come to a blog like this one because we will not feed their denial. Some will stop by, try to convince us we are wrong, and move on. The only person they are really trying to convince is themselves.
When the markets enter the fear stage, the little voice inside of each buyer gets louder and louder. This boils over into anger, frustration, anxiety, etc. The individual desperately is seeking ways to maintain denial — perhaps they read Gary Watts Real Estate Outlook 2007 — but reality becomes stronger than denial. As a mechanism to break down the denial they imagine the possibility that reality they are trying to deny is the truth. This leads to depression and detachment as reality is too painful to accept.
Finally, "as the going gets tough, the tough get going," and the individual seeks ways to get out of the problem through emotional bargaining. Some will take action. Perhaps it is lowering an asking price, taking the property off the market and doing some renovations to "add value." Some will not take action, and they lapse back into denial because the market is "coming back soon." Note that these psychological stages all occur in the fear stage of the market. Those owners who chose to lower their price as part of their bargaining may get out with minimal losses (assuming they lower it enough to actually sell.) Those that chose other courses of action, lose much more money.
Each individual only reaches acceptance when they sell their house. This is when we enter the stage of market capitulation. Collectively, everyone in the market accepts prices are going to drop further, and they need to get out: Now! Of course when everyone knows prices are going to drop, and everyone is trying to sell, there are no buyers. This puts prices into free-fall until buyers are ready to buy again.
Since buyers in the aftermath of a bubble tend to be the risk adverse who did not participate in it, they will make cautiously low offers on properties. This cautious buying together with desperate sellers causes the market to drop below normal valuation standards. The market enters the despair stage. Here the market participants think nobody wants the asset, and nobody ever will again. Of course, nothing could be farther from the truth as those who recognize the fundamental value of the asset are buying it in preparation for the next cycle.
Why does it happen this way?
Now that we know what happens, the next logical question is why does it happen. To fully understand this, one must look into the mind of the market participants at key stages in the process, examine their circumstances and see the decisions they must make. While we go through this exercise, I am going to compare and contrast the thought process of a trader with that of the general public.
The first and most obvious difference between traders and the general public is their holding time. Traders buy with intention to sell for a profit at a later date. Traders know why they are entering a trade, and they have a well thought out plan for their exit. The general public adopts a "buy and hold" mentality where assets are accumulated with a supposed eye to the long term. Everyone wants to be the next Warren Buffet. In reality this buy-and-hold strategy is often a "buy and hope" strategy — a greed induced emotional purchase without proper analysis or any exit strategy. Since they have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them. In short, it is an investment method guaranteed to be a disaster.
A bubble rally is usually kicked off by some exogenous event. In a securities market, it may be a very large order hitting the trading floor, and in a real estate market it can be a dramatic lowering of interest rates. Whatever the cause, a series of events is set in motion which repeats with a remarkable consistency. It repeats on multiple timeframes in all financial markets.
At the beginning of the enthusiasm stage, prices are already inflated, so there is cautious buying from traders looking for trends and momentum. Prices rise steadily and more attention is drawn to the market. The market sentiment turns very bullish. Buyers are everywhere and sellers are scarce. The general public takes notice and begins to participate in larger numbers.
In the greed stage, the bullish sentiment reaches a feverish pitch and prices rise very rapidly. Everyone in the market is making money and everyone believes it will go on forever. The greed stage is where the behavior of traders and the general public really start to diverge. Traders recognize it isn't going to go on forever because prices are unsupported by fundamentals: They sell. The general public is convinced prices can rise forever: They buy — from the traders. (If you don't think this happens in the housing market, I suggest you read Still Renting from Pimco trader Mark Kiesel.)
Think about this for a moment: most people who are bullish already own the asset, but for prices to continue to rise, there must be more buying. For buying to occur, someone who was either bearish or ignorant of the rally must be convinced to buy. In other words, a greater fool must be found. (Remember the National Association of Realtors $40M add campaign?) Once everyone is made aware of the market rally and is convinced to buy, you simply run out of new buyers. Once there are no more potential buyers, prices can only go down.
Right now, we are in the denial stage. Prices have not dropped enough to cause real fear. Denial is apparent in polls like this one: Out of touch with realty reality where 85 percent believe their home will rise in value during the next five years, and 63 percent believe a house is a good investment. That is serious denial.
It is also apparent in the number of homes purchased during the greed stage that are held for sale at breakeven prices — even if this is above market. When the inventory is large, and houses stay on the market for a long time, prices are too high. Sellers who refuse to lower their prices to take a small loss are in denial about the current state of the market. They believe bids will increase and some buyer will come along and pay their price — after all, that is the way it was just 2 years ago.
Buyers who bought in the enthusiasm stage are still ahead, so they feel no urgency to sell. They have made good money already and they will hold on with hopes of making a little more. Since they believe the asset will appreciate again (and they have no exit strategy), this group of buyers does not sell.
In contrast, the few traders who still hold positions liquidate and go back into cash. Successful traders recognize denial as a signal to exit their positions to lock in profits or prevent further damage.
So why can't prices rally here? There are two reasons: First, the pool of buyers is depleted as discussed above, and second, the excesses of the bubble are causing a contraction in credit terms. There are fewer buyers, and those who might want to buy can't borrow the large sums needed to push prices higher. Market psychology hasn't really turned yet, but technical factors are getting in the way. This same phenomenon occurred in our last credit induced financial bubble which resulted in the savings and loan fiasco of the 1980's and it helped facilitate the decline of the early 90's. What is Past is Prologue.
This fall and winter, we are likely to see a liquidation of bank held inventory. Banks will try to get their wishing prices through the prime selling season, but by the end of the year, there will be pressure to get these non-performing assets off their books. The fire sale of bank foreclosures and the continued tightening of credit will drive prices down an additional 5% to 10%. This will cause some major problems for owners of residential real estate.
At this point, successful traders have all exited the market, although a few knife-catchers jump back in during the bull trap and become bagholders. Greed stage buyers are now seriously underwater. Comps are selling for 10% less than their breakeven price, and there is little hope that prices will rally. Some will sell at this point and take a loss, but most will not.
People who bought in the enthusiasm stage come up to their breakeven price and face the same decision our greed stage buyers faced earlier: sell now or hold out for a rally. Even though there is reason to fear, most will not sell here. They will regret it later, but they will hold on.
- The most important psychological change in the market as we enter the fear stage is the belief that the rally is over. Price rallies are self-sustaining: prices go up because rising prices induces people to buy which in turn drives prices even higher. Once it is widely believed that the rally is over, it is over. Market participants who once only cared about rising prices now become concerned about valuations. Since prices are far above fundamental values and prices are not rising, there is little incentive to buy. The rally is dead.
- Another major psychological change occurs in this stage after people accept the rally is dead: People reassess and change their relationship to debt. During the rally, debt became a means to take a position in the housing commodity market. Nobody cared how much they were borrowing because they never intended to pay off the loan through payments from their wage income. Everyone believed they would pay off whatever they borrowed in the future when they sold the house for more than they paid. Once prices stop going up, people realize they are simply renting from the bank, and the only way to get ahead and build equity is to pay off a mortgage. The desire to borrow 10 times income diminishes rapidly as people realize they could never pay off such a large sum. What started in the denial stage as an involuntary contraction of credit, in the fear stage becomes a voluntary contraction of credit as people simply do not want to borrow such large sums.
So why can't prices rally here? There are even fewer buyers in the market and a reduced appetite for debt due to the change in market psychology. There are more and more sellers are either choosing to sell or being forced to sell. Since there are more sellers than buyers, prices continue to drop.
During the fear stage, a majority of buyers during the rally go underwater on their mortgage. Most will endure the pain and stress. In the past, since the bubbles of the 80's and 90's were built on conventional mortgages, people just held on. In this bubble, people used exotic loan financing terms, and they simply cannot afford to make the payments. They will borrow from other sources until finally the entire system reaches a breaking point and they implode in foreclosure and bankruptcy.
The transition from the fear stage to the capitulation stage is caused by the infectious belief that the rally is over. There is a tipping point where a critical mass of market participants either decide to sell or are forced to sell. Once this point is reached, selling causes prices to decline further. This convinces even more people the rally is over which begets even more selling: a downward spiral. The capitulation stage is the counterpart of the greed stage. Sellers are everywhere and buyers are scarce.
In securities trading, the mechanism for compelling people to sell at a loss is anxiety and emotional distress, and the mechanism for force is a stoploss or a broker's margin call. In residential real estate, people are also compelled to sell by anxiety, and the mechanism for force is foreclosure. We know foreclosures are going to be particularly bad in this bubble due to the exotic financing and adjustable rate mortgage resets.
Each market participant has a different threshold for pain. Some give up early; some give up later; some stubbornly try to hold on, but in the end, by choice or by force, everyone sells out and capitulates to the forces of the market.
From a perspective of market psychology, it is difficult to tell when the capitulation stage ends and the despair stage begins. Both stages have an extremely negative bearish sentiment. The general public is still selling. What makes the despair stage different is that buyers who focus on fundamentals like rental savings or positive cashflow return to the market and begin buying (Remember Rent Savers and Cashflow Investors from How Inflated are House Prices? ) These buyers are not concerned with appreciation, they simply want an asset which provides a cash return on their investment. They are not frightened by falling prices because their financial returns are independent of the asset's market valuation. It is the return of these people to the market which creates a bottom.
Houses should not be viewed as a commodity to trade. Most people lack the financial sophistication to successfully trade in commodity markets. Buying and hoping prices go up is not a successful strategy (as a great many are about to find out). Volatility in housing prices is harmful to the community as the financial and emotional costs of the inevitable price crash are just too great. Everyone pays a price. Renters like myself who chose not to participate are forced to wait to obtain the security of home ownership at an affordable price, and buyers who endure the crash… well, their pain is obvious.
I don't know how to solve this problem, but I suspect government intervention will only make it worse. Part of the problem is embedded into the local culture (remember Southern California’s Cultural Pathology?) Perhaps after the pain we are about to witness is over, people will learn their lessons and break the cycle; however, human nature being what it is, I doubt it.
People have commented on the confidence I have in my analysis of the market. To be very honest, most of the analysis came later. Early in this bubble I witnessed inflated prices begin to rise. My years of experience trading the markets told me it was a beginning of a financial bubble. I didn't know exactly what was causing it, I didn't know how high it would go or how long it would last; I just knew it would prove to be a bad time to buy. Even after watching prices go up significantly from there, I knew it wasn't going to last. I had seen the cycle too many times before. I was witness to the insanity as it unfolded, but it has only been in the last year that I became more interested and really researched the details of causes of this bubble. I have greatly increased my depth of understanding of this phenomenon, but I have never doubted my initial instinct; I still don't.