When we follow an individual stock, or a stock market average like the Dow or Nasdaq 100, most of the time most of what we see is random movements. At one extreme the entire market can be seen as random, as espoused in A Random Walk Down Wall Street and elsewhere.
As an approximation that might be true, and so it may not be a bad suggestion that anyone who wants to participate in stocks, but does not want to be hassled by doing their own research and analysis, should just invest in index funds.
Of course we know the real world of corporate profits is not just random. Apple's stock rise is not just the result of randomness, nor is Blackberry's fall. You can make a fortune investing in the right companies when they are small and (hopefully) watching them grow.
Here I want to take a preliminary, non-scientific, look at some of the causes of "random" stock movements caused by buying and selling that are not driven by the anticipation or demonstration of increased or decreased earnings.
I began thinking about this back in the 1980's, when I was starting my own business while still working as a paralegal. I worked in a probate office, and this is what happened on an almost daily basis: stocks were sold. The stocks had typically been accumulated during a lifetime, then the owner had died, and then the estate was tied up in probate for a while. The "kids" -- often they were in their 60s -- had been waiting to inherit most of their lives. The moment it was legally possible the stocks were sold, converted to cash to be distributed.
It was rare to see anyone say, "hey, I'll sell all the stocks but Apple". Or "wait another month, the market is down today, we'll get more money if we wait a month." In fact that never happened that I recall.
So did your stock from $2 a share in an hour today? It could be bad news is circulating you have not heard about; it could be someone manipulating the price; or it could be that Wasp Savemoney, deceased, had a chunk of the company and it was dumped all at once.
Two seasonal times of selling stand out. College funds are also saved over a decade or more, only to be dissolved rather quickly starting with the first Freshman year tuition payment. When taxes are due, leading up to mid-April, so selling or failing to buy will be due to that.
When a house is bought, it may require cashing out stock to make the down. That, again, is timed to the escrow, not the ideal timing for maximizing stock value.
The financial news often accounts for stock market movements with bland terms like "profit taking." If selling is profit taking, is buying profit giving away?
A big factor in selling is portfolio limits. Wise investors do not allow themselves to become too concentrated in any particular stock. This is particularly true of professionally managed money. In my personal portfolio I am not supposed to have more than 10% in any one stock. In a large pension fund or mutual fund the percent might be 5% or even 2%.
So if a stock goes up enough, portfolio rules force managers to do some selling. They might think that the stock will continue to go up; they might have some power to make limited exemptions. But they are certainly not going to buy more of the stock, and at some point they must sell. For the manager this is not random, it is causal, but it appears random to the rest of the market.
If, like me, you manage your own investment portfolio, you want to know what is really going on. Mostly this is at the company level. You want to know factors contributing to next quarter's or next year's or next decade's profits.
But it is oh so much easier to while away the hours watching prices move. Perhaps even trying to outguess the other guessers.
Just keep in mind that people die on a daily basis, and some of them have substantial portfolios, and those almost always get sold and converted to cash. A bad flu sweeping through the more elegant nursing homes in December can cause the market to sink one day the following year.
To see a list of stocks I write about go here: William Meyers stock reports
To pick a stock randomly try my Random Stock Picker
Showing posts with label random walk. Show all posts
Showing posts with label random walk. Show all posts
Wednesday, September 24, 2014
Sunday, February 9, 2014
There is no Stock Market
If you are an investor in financial instruments like stocks, bonds, options and derivatives, the most important thing to remember is: There Is No Stock Market.
When we talk loosely of "the stock market," it is not a problem as long as we keep in mind the reality underlying this terminology.
A stock market can be defined as a marketplace where stocks are bought and sold. Such stock markets exist. When I first visited New York City, in the 1970s, stock markets were not much different than they had been in the Netherlands in the 1400's or on Wall Street in the 1800's, except in scale. You could walk to a physical location like the New York Stock Exchange, literally on Wall Street, and watch a bunch of men (and I mean male humans) yelling, cryptically offering to buy or sell stock from each other, furiously writing down any transaction actually agreed upon.
Now most stocks and other financial instruments are traded electronically, with men in pits just an anachronism. Even during the men in pits era people began referring to indexes like the Dow Industrials or the S&P 500 as being "the market." It simplified things. Did the market go up or down today, this week, this year? Just look at the Dow numbers.
Stock prices, which represent the value of shares of individual companies, do have a loose tendency to go up and down together as a group. But the market being up or down, or flat, is a result of a summation and averaging process. Individual stocks that are included in the averages drive the indexes up and down, not the other way around [with the exception of index funds, which are obligated to buy or sell all the stocks in an index in the same proportion as they are represented in the index].
Individual stocks, in turn, go up and down depending on what bids there are to buy and sell their shares. People (and institutions they control) buy and sell shares all the time for all sorts of reasons.
If you want there to be a stock market for trading purposes you can buy an index fund. There are some powerful reasons for ordinary investors to buy index funds rather than individual stocks or managed mutual funds that in turn try to beat the indexes by buying and selling individual stocks.
Long ago certain traders and economists noticed that stock market movements (both pricing of individual stocks and of market averages) tend to be random over most periods of time. Take that observation as an ultimate truth and anyone who beats or is beaten by "the market" is simply a statistical variation, a lucky or unlucky gambler. Of those investors that do not exactly match the market average, half will to better than average and half worse than average over a given period of time. [For fuller arguments of this viewpoint see A Random Walk Down Wall Street by Burton G. Malkiel, Fooled by Randomness
by Nassim Nicholas Taleb, or for a more analytic presentation Pricing the Future
by George G. Szpiro]
Generally people buy a stock because they expect to make a profit on the investment. They may receive dividends, and the stock may go up in value over time. But most stocks most of the time are held by institutions, like pension funds and trust funds and 401k accounts. In other words, other people's money, which lessens the incentive to maximize returns. When stocks are bought and sold a commission (broker's fee) is generated, so there are individuals and institutions out there that encourage buying and selling for its own sake, which hurts returns which also adds to randomness.
Still, basic principles of investment apply. If a person buys the stock of an individual company and the price paid is less than the stream of future profits the company will generate, over time the investor will be rewarded with stock price appreciation and perhaps dividends. If a person buys a the stock of an individual company and the price paid is more than the stream of future profits the company will generate, over time the investor will see the price deteriorate.
By understanding the specifics of a company, including its culture, intellectual property, the profit margins that are "natural" for the particular business, and its position versus any competition, it is possible to be right more often than wrong about future profit streams.
Because sometimes unexpectedly bad things happen to good companies, and unexpectedly good things happen to bad (or at least mediocre) companies, most investors spread out there investments over a variety of companies.
In the Random Markets theory information spreads rapidly, so that anyone who cares to can know the prospects of any given company. This theory breaks down badly in reality. Most people don't know enough about business, or specific kinds of businesses, to do a good analysis themselves. Most are not willing to take the time to research a bunch of companies just to find a few gems. So most people trust specialists, ranging from the analysts of major Wall Street brokerage houses (sell-side analysts), to financial advisors and brokers, to tip-sheet writers, to poorly paid Internet journalists.
All these professionals charge money, one way or another, for their services. And they should: it takes time to research stocks and it takes marketing dollars to land clients, and then there are costs of operations. Despite that, on average they get an average return on the portfolios they create. So you can do better (unless you are one of the lucky people who gets an exceptional broker or financial advisor) by going to a low-cost Internet-based broker and buying stock-index funds.
Now suppose you are like me and think you can outsmart the professionals, including the Wall Street analysts (who after all mostly go straight from college or an MBA program into these positions with little real life or actual experience in business). I believe that if you can be unemotional, and do your homework, you can beat the averages, because I have done it.
The most important thing to remember, as you learn to spend long hours reading SEC documents and commentaries like mine at places like Seeking Alpha, is not that there is always a lot of pump-and-dump activity going on from penny stocks all the way up to Dow Industrials (and the reverse, short and trash activity). Although you should keep that in mind.
You should not care what the Dow did on any given day, or month, or year. Or, if you are like me, what the NASDAQ-100 did [most of my stock picks are from that index]. Except maybe as a benchmark for seeing if your strategy, or your picks, are doing better than the index funds.
There Is No Stock Market! There are only individual companies, and prices quoted through an auction system on a minute-by-minute basis. News may effect a stock's price on any given day, including news about the company's audited financial numbers for a quarter, but the only thing that really matters is the future stream of profits (that could be, but usually are not, doled out to the shareholders).
Do not hope for "the market" to bail out your bad choices, just because that has happened at times. The best way to get in trouble is to think that other fools are going to bid up a stock when there is no foundation for its price. If you own a stock that you cannot justify by coldly analyzing its potential for profits, you are the fool.
Down markets, when people panic and sell without discretion, as happened in 2008, are your friend. You should have cash to buy bargains because you sold overpriced stocks before the bust. But just because a company's price has fallen, even substantially, does not mean it is a good buy. Take your time and sort through the wreckage for the gems.
When you keep researching stocks and most seem to be priced higher than you can justify, revisit your holdings, because they may have risen to a point that can no longer be justified. But again, just because a stock went up does not mean you should sell it. The question to ask is: Why did the stock go up? If it was enthusiasm of newcomers, rather than because prospects for profit growth are still great, it is likely time to trade in that stock for cash.
While this advice is too general to help you select individual stocks, it is something to always keep in mind. Wall Street professionals tend to forget it. They get caught up in their own hype (which can include hyping certain stocks down, although most hype is in the upward direction).
There is no stock market, but being contrary is not in itself a strategy. If you go contrary to the sell-side Wall Street brokerage recommendations, be sure to have a very good reason for doing so. Some not-sufficiently good reasons: a guru recommended the stock. A relative recommended a stock. A financial advisor recommended a stock. Etc.
There is no stock market. There are only averages. If average is okay for you, invest in index funds. Baring the apocalypse, profits grow over time, and index funds grow over time. If you did not sell at the top, or at least half-way down, it is idiotic to sell at the bottom.
And keep diversified!
When we talk loosely of "the stock market," it is not a problem as long as we keep in mind the reality underlying this terminology.
A stock market can be defined as a marketplace where stocks are bought and sold. Such stock markets exist. When I first visited New York City, in the 1970s, stock markets were not much different than they had been in the Netherlands in the 1400's or on Wall Street in the 1800's, except in scale. You could walk to a physical location like the New York Stock Exchange, literally on Wall Street, and watch a bunch of men (and I mean male humans) yelling, cryptically offering to buy or sell stock from each other, furiously writing down any transaction actually agreed upon.
Now most stocks and other financial instruments are traded electronically, with men in pits just an anachronism. Even during the men in pits era people began referring to indexes like the Dow Industrials or the S&P 500 as being "the market." It simplified things. Did the market go up or down today, this week, this year? Just look at the Dow numbers.
Stock prices, which represent the value of shares of individual companies, do have a loose tendency to go up and down together as a group. But the market being up or down, or flat, is a result of a summation and averaging process. Individual stocks that are included in the averages drive the indexes up and down, not the other way around [with the exception of index funds, which are obligated to buy or sell all the stocks in an index in the same proportion as they are represented in the index].
Individual stocks, in turn, go up and down depending on what bids there are to buy and sell their shares. People (and institutions they control) buy and sell shares all the time for all sorts of reasons.
If you want there to be a stock market for trading purposes you can buy an index fund. There are some powerful reasons for ordinary investors to buy index funds rather than individual stocks or managed mutual funds that in turn try to beat the indexes by buying and selling individual stocks.
Long ago certain traders and economists noticed that stock market movements (both pricing of individual stocks and of market averages) tend to be random over most periods of time. Take that observation as an ultimate truth and anyone who beats or is beaten by "the market" is simply a statistical variation, a lucky or unlucky gambler. Of those investors that do not exactly match the market average, half will to better than average and half worse than average over a given period of time. [For fuller arguments of this viewpoint see A Random Walk Down Wall Street by Burton G. Malkiel, Fooled by Randomness
by Nassim Nicholas Taleb, or for a more analytic presentation Pricing the Future by George G. Szpiro]Generally people buy a stock because they expect to make a profit on the investment. They may receive dividends, and the stock may go up in value over time. But most stocks most of the time are held by institutions, like pension funds and trust funds and 401k accounts. In other words, other people's money, which lessens the incentive to maximize returns. When stocks are bought and sold a commission (broker's fee) is generated, so there are individuals and institutions out there that encourage buying and selling for its own sake, which hurts returns which also adds to randomness.
Still, basic principles of investment apply. If a person buys the stock of an individual company and the price paid is less than the stream of future profits the company will generate, over time the investor will be rewarded with stock price appreciation and perhaps dividends. If a person buys a the stock of an individual company and the price paid is more than the stream of future profits the company will generate, over time the investor will see the price deteriorate.
By understanding the specifics of a company, including its culture, intellectual property, the profit margins that are "natural" for the particular business, and its position versus any competition, it is possible to be right more often than wrong about future profit streams.
Because sometimes unexpectedly bad things happen to good companies, and unexpectedly good things happen to bad (or at least mediocre) companies, most investors spread out there investments over a variety of companies.
In the Random Markets theory information spreads rapidly, so that anyone who cares to can know the prospects of any given company. This theory breaks down badly in reality. Most people don't know enough about business, or specific kinds of businesses, to do a good analysis themselves. Most are not willing to take the time to research a bunch of companies just to find a few gems. So most people trust specialists, ranging from the analysts of major Wall Street brokerage houses (sell-side analysts), to financial advisors and brokers, to tip-sheet writers, to poorly paid Internet journalists.
All these professionals charge money, one way or another, for their services. And they should: it takes time to research stocks and it takes marketing dollars to land clients, and then there are costs of operations. Despite that, on average they get an average return on the portfolios they create. So you can do better (unless you are one of the lucky people who gets an exceptional broker or financial advisor) by going to a low-cost Internet-based broker and buying stock-index funds.
Now suppose you are like me and think you can outsmart the professionals, including the Wall Street analysts (who after all mostly go straight from college or an MBA program into these positions with little real life or actual experience in business). I believe that if you can be unemotional, and do your homework, you can beat the averages, because I have done it.
The most important thing to remember, as you learn to spend long hours reading SEC documents and commentaries like mine at places like Seeking Alpha, is not that there is always a lot of pump-and-dump activity going on from penny stocks all the way up to Dow Industrials (and the reverse, short and trash activity). Although you should keep that in mind.
You should not care what the Dow did on any given day, or month, or year. Or, if you are like me, what the NASDAQ-100 did [most of my stock picks are from that index]. Except maybe as a benchmark for seeing if your strategy, or your picks, are doing better than the index funds.
There Is No Stock Market! There are only individual companies, and prices quoted through an auction system on a minute-by-minute basis. News may effect a stock's price on any given day, including news about the company's audited financial numbers for a quarter, but the only thing that really matters is the future stream of profits (that could be, but usually are not, doled out to the shareholders).
Do not hope for "the market" to bail out your bad choices, just because that has happened at times. The best way to get in trouble is to think that other fools are going to bid up a stock when there is no foundation for its price. If you own a stock that you cannot justify by coldly analyzing its potential for profits, you are the fool.
Down markets, when people panic and sell without discretion, as happened in 2008, are your friend. You should have cash to buy bargains because you sold overpriced stocks before the bust. But just because a company's price has fallen, even substantially, does not mean it is a good buy. Take your time and sort through the wreckage for the gems.
When you keep researching stocks and most seem to be priced higher than you can justify, revisit your holdings, because they may have risen to a point that can no longer be justified. But again, just because a stock went up does not mean you should sell it. The question to ask is: Why did the stock go up? If it was enthusiasm of newcomers, rather than because prospects for profit growth are still great, it is likely time to trade in that stock for cash.
While this advice is too general to help you select individual stocks, it is something to always keep in mind. Wall Street professionals tend to forget it. They get caught up in their own hype (which can include hyping certain stocks down, although most hype is in the upward direction).
There is no stock market, but being contrary is not in itself a strategy. If you go contrary to the sell-side Wall Street brokerage recommendations, be sure to have a very good reason for doing so. Some not-sufficiently good reasons: a guru recommended the stock. A relative recommended a stock. A financial advisor recommended a stock. Etc.
There is no stock market. There are only averages. If average is okay for you, invest in index funds. Baring the apocalypse, profits grow over time, and index funds grow over time. If you did not sell at the top, or at least half-way down, it is idiotic to sell at the bottom.
And keep diversified!
Monday, February 21, 2011
Random Walks versus Purposeful Forays
The March 2011 Scientific American includes "Financial Flimflam" by Michael Shermer, subtitled "why economic experts' predictions fail". But it is not so much about economic predictions as about the theory that index funds are a better investment than managed funds. He claims the market average return in 2010 was 2.5% higher than the average of the ten largest managed funds.
Index funds, of course, have their own perils. A lot of people bailed out of their index funds some time in 2008 or early in 2009, as a sort of stop-loss measure. Then they missed the market runnups in later 2009 and in 2010. Thus gutting their retirements.
Since I do my own research and make my own investment decisions, and also get paid to do specific research and analysis by a fund manager, I think it is fair to wonder if I might be better off just buying into an index fund like so many other people and institutions.
Lately I have had an extraordinary rate of return because my portfolio contains only 15 stocks, and those include 3 with extraordinary returns of late: TTM, the Printed Circuit Board manufacturer; Dot Hill, a storage company, and Dendreon, the maker of Provenge for prostate cancer. In the past I have had other stocks hitting extraordinary returns, but because I have tried a number of risky, turn-around, small cap situations, I have also lost all the money I invested in 3 stocks over the past decade. There have also been times when my stocks lagged the market. Partly this is because since I typically play Nasdaq 100, or smaller, stocks, so they typically go down more in down markets, but up more in up markets.
I agree that if you are paying someone to manage your portfolio, they need to beat the market enough to pay their management fees and then some. Otherwise you could do better by creating your own index fund. It is not hard, you could for example buy equal amounts of the Dow 30 and the Nasdaq 100 or S&P 500 or any other known set of stocks.
Still, there are people like Warren Buffet who had very long runs of better than average returns. That is not just luck.
Large managed funds have trouble beating the market partly because they are the market. Their individual stock positions are so large that their creating or leaving a position, or even trimming, moves stock prices. They also tend to be in a relatively large number of stocks, which again dilutes their performance back towards the market average.
To beat the market it really helps to play on a small enough scale that your buys and sells don't affect the stock price substantially.
It also helps to see the curve. Here I mean seeing more than the statistics we all tend to rely on, revenue growth and earnings growth and margins and cash. You need to see future value where others are missing it. You also need to be very serious about weighing risk. Truth be told, I thought Dendreon was riskier than Anesiva, but Anesiva went down with my investment, while Dendreon took me up by a factor of ten. If both had sunk, I would be writing a far gloomier story today. Interestingly, in addition to stocks with high risk levels, I always keep stocks with good potential for returns and relatively lower risk. Some of those stocks have performed badly for me, but none went out of business.
I basically doubled my money in the stock market during a period of time when the market went basically no where. I balanced my risks and made my mistakes, and have been better at avoiding mistakes lately. In retrospect, or course, I could have put every penny I had into Dendreon, but that did not look wise at the time. Backtesting is interesting, but you have to go with what you know in reality, at the time of investment.
On the other hand I do an enormous amount of research, considering the size of my portfolio. I don't just invest in biotechnology stocks; I study biology text books and journal articles. I don't just invest in computer technology, I do my best to keep up with the breadth of its developments. Also, I try to think like an owner of the companies I invest in. I like companies that invest wisely in the future and run a tight ship.
Frankly, unless you enjoy doing research, you are better off in an index fund. But if you are willing to do your homework (and it really is a lot of homework), you have a good chance of beating an index fund if you are an astute individual investor.
You should check out the Scientific American article because it has some other information, especially about investor psychology. I love this bit: "Being deeply knowledgeable on one subject narrows focus and increases confidence but also blurs the value of dissenting views and transforms data collection into belief confirmation."
Above all, a smart investor looks most closely at the data that challenges current beliefs.
If you aren't familiar with it, see the Random Walk Hypothesis at Wikipedia.
Keep Diversified!
Index funds, of course, have their own perils. A lot of people bailed out of their index funds some time in 2008 or early in 2009, as a sort of stop-loss measure. Then they missed the market runnups in later 2009 and in 2010. Thus gutting their retirements.
Since I do my own research and make my own investment decisions, and also get paid to do specific research and analysis by a fund manager, I think it is fair to wonder if I might be better off just buying into an index fund like so many other people and institutions.
Lately I have had an extraordinary rate of return because my portfolio contains only 15 stocks, and those include 3 with extraordinary returns of late: TTM, the Printed Circuit Board manufacturer; Dot Hill, a storage company, and Dendreon, the maker of Provenge for prostate cancer. In the past I have had other stocks hitting extraordinary returns, but because I have tried a number of risky, turn-around, small cap situations, I have also lost all the money I invested in 3 stocks over the past decade. There have also been times when my stocks lagged the market. Partly this is because since I typically play Nasdaq 100, or smaller, stocks, so they typically go down more in down markets, but up more in up markets.
I agree that if you are paying someone to manage your portfolio, they need to beat the market enough to pay their management fees and then some. Otherwise you could do better by creating your own index fund. It is not hard, you could for example buy equal amounts of the Dow 30 and the Nasdaq 100 or S&P 500 or any other known set of stocks.
Still, there are people like Warren Buffet who had very long runs of better than average returns. That is not just luck.
Large managed funds have trouble beating the market partly because they are the market. Their individual stock positions are so large that their creating or leaving a position, or even trimming, moves stock prices. They also tend to be in a relatively large number of stocks, which again dilutes their performance back towards the market average.
To beat the market it really helps to play on a small enough scale that your buys and sells don't affect the stock price substantially.
It also helps to see the curve. Here I mean seeing more than the statistics we all tend to rely on, revenue growth and earnings growth and margins and cash. You need to see future value where others are missing it. You also need to be very serious about weighing risk. Truth be told, I thought Dendreon was riskier than Anesiva, but Anesiva went down with my investment, while Dendreon took me up by a factor of ten. If both had sunk, I would be writing a far gloomier story today. Interestingly, in addition to stocks with high risk levels, I always keep stocks with good potential for returns and relatively lower risk. Some of those stocks have performed badly for me, but none went out of business.
I basically doubled my money in the stock market during a period of time when the market went basically no where. I balanced my risks and made my mistakes, and have been better at avoiding mistakes lately. In retrospect, or course, I could have put every penny I had into Dendreon, but that did not look wise at the time. Backtesting is interesting, but you have to go with what you know in reality, at the time of investment.
On the other hand I do an enormous amount of research, considering the size of my portfolio. I don't just invest in biotechnology stocks; I study biology text books and journal articles. I don't just invest in computer technology, I do my best to keep up with the breadth of its developments. Also, I try to think like an owner of the companies I invest in. I like companies that invest wisely in the future and run a tight ship.
Frankly, unless you enjoy doing research, you are better off in an index fund. But if you are willing to do your homework (and it really is a lot of homework), you have a good chance of beating an index fund if you are an astute individual investor.
You should check out the Scientific American article because it has some other information, especially about investor psychology. I love this bit: "Being deeply knowledgeable on one subject narrows focus and increases confidence but also blurs the value of dissenting views and transforms data collection into belief confirmation."
Above all, a smart investor looks most closely at the data that challenges current beliefs.
If you aren't familiar with it, see the Random Walk Hypothesis at Wikipedia.
Keep Diversified!
Monday, June 25, 2007
Housing Market Distortions
Most traditionalist economists believe that markets are always in equilibrium. I believe that markets are almost always out of equilibrium. The questions speculators have to answer correctly are: how much, and in which direction.
Comparing the housing market and the stock market can give a lot of insight into causes of disequilibrium. The stock market can be broken down into stocks that are heavily traded and stocks that are thinly traded. To a large extent the national housing market behaves like a heavily traded stock, but local markets trade more like thinly traded stocks.
Another useful dichotomy: is the trading auction style, or swap style? By swap style I mean the traditional markets as described by Adam Smith: a rational (or at least savvy) person at each end, trading something of value, when there is an elastic supply of the two items (one usually being money) to be traded.
Today there is an almost 10 month supply of unsold houses on the U.S. national market. Two years ago houses more often than not sold the day they were put on the market; houses under construction sold before construction began. Yet the economy is arguably stronger on the whole today that it was two years ago. Anyone who argues that the housing market, or sale prices of housing, is always at equilibrium is saying nothing. They are defining equilibrium to be whatever happens. Same for stock prices.
Suppose you are going to buy something; it could be a stock or a house. As long as the price is rising and continuing to rise it makes sense to buy as soon as possible. Maybe normally you would save up a 20% down to get a good interest rate on a mortgage; but with prices increasing, it makes more economic sense to put 5% down and pay a higher interest rate now, rather than waiting two (or ten) years to save up the down.
The same becomes true when prices are falling. Why buy house now, even if you want it and think it will be a good long term investment, if you think you can buy it for 5% or 10% less if you just wait 6 months?
Rising prices accelerate demand, which in turn makes prices rise more. That is one reason why stock prices and housing prices tend to be out of equilibrium. Falling prices tend to dampen immediate demand, which in turn causes prices to fall more. That is the other main reason prices are usually out of equilibrium. These tendencies are the basis of macroeconomic cycles and of stock market price fluctuations that may last hours, weeks or even years (or, with super-fast computerized program trades, fractions of a second).
Auction systems aggravate these trends, partly because of human psychology and partly because they create a short-term artificial scarcity or surplus. Price swings in thinly traded, illiquid stocks display this.
Buyers in the housing market aren't going to be in a hurry until prices start rising again. The exact turning point won't be obvious, partly because it will take place in different localities at different times. The willingness, and ability, of lenders to finance purchases may stall or accelerate the process of finding a bottom.
But there will be a bottom. Strangely, the longer it takes to reach it, and the deeper the retreat in prices is, the more people will think there is no bottom.
Comparing the housing market and the stock market can give a lot of insight into causes of disequilibrium. The stock market can be broken down into stocks that are heavily traded and stocks that are thinly traded. To a large extent the national housing market behaves like a heavily traded stock, but local markets trade more like thinly traded stocks.
Another useful dichotomy: is the trading auction style, or swap style? By swap style I mean the traditional markets as described by Adam Smith: a rational (or at least savvy) person at each end, trading something of value, when there is an elastic supply of the two items (one usually being money) to be traded.
Today there is an almost 10 month supply of unsold houses on the U.S. national market. Two years ago houses more often than not sold the day they were put on the market; houses under construction sold before construction began. Yet the economy is arguably stronger on the whole today that it was two years ago. Anyone who argues that the housing market, or sale prices of housing, is always at equilibrium is saying nothing. They are defining equilibrium to be whatever happens. Same for stock prices.
Suppose you are going to buy something; it could be a stock or a house. As long as the price is rising and continuing to rise it makes sense to buy as soon as possible. Maybe normally you would save up a 20% down to get a good interest rate on a mortgage; but with prices increasing, it makes more economic sense to put 5% down and pay a higher interest rate now, rather than waiting two (or ten) years to save up the down.
The same becomes true when prices are falling. Why buy house now, even if you want it and think it will be a good long term investment, if you think you can buy it for 5% or 10% less if you just wait 6 months?
Rising prices accelerate demand, which in turn makes prices rise more. That is one reason why stock prices and housing prices tend to be out of equilibrium. Falling prices tend to dampen immediate demand, which in turn causes prices to fall more. That is the other main reason prices are usually out of equilibrium. These tendencies are the basis of macroeconomic cycles and of stock market price fluctuations that may last hours, weeks or even years (or, with super-fast computerized program trades, fractions of a second).
Auction systems aggravate these trends, partly because of human psychology and partly because they create a short-term artificial scarcity or surplus. Price swings in thinly traded, illiquid stocks display this.
Buyers in the housing market aren't going to be in a hurry until prices start rising again. The exact turning point won't be obvious, partly because it will take place in different localities at different times. The willingness, and ability, of lenders to finance purchases may stall or accelerate the process of finding a bottom.
But there will be a bottom. Strangely, the longer it takes to reach it, and the deeper the retreat in prices is, the more people will think there is no bottom.
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