Friday, October 27, 2006
Real Estate Market Timing
After Pinocchio and Cinderella, Real Estate Market Timing is my third preferred fairy tale. I like it so much, in fact, that I wanted to share it with my readers – thus this Post.
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The United States, Canada and all other modern industrial economies experience significant swings in economic activity. In some years most industries are booming and unemployment is low; in other years most industries are operating well below capacity and unemployment is high. Periods of economic expansion are typically called booms; periods of economic decline are called recessions or depressions. The combination of booms and recessions, the ebb and flow of economic activity, is called the economic cycle.
Of all the industries contained in the economic basket of goods and services, Real Estate is the one that is particularly susceptible to the ups and downs of economic cycles simply because it is a big ticket industry. It is therefore important for all those involved into real estate investing, to try to anticipate market movements in order to maximize profits and optimize performance. This is, in fact, the textbook definition of market timing. Market timing means buying low and selling high, and we all know that this is the key to successful investing.
So, therefore, market timing is logical. It is also deceptively simple - buy properties when prices are low, and sell them when prices are high. Unfortunately, however, in many ways the term "economic cycle" is misleading. "Cycle" seems to imply that there is some regularity in the timing and duration of upswings and downswings of economic activity. This could not be farther from the truth, especially in Real Estate. Booms and recessions occur at irregular intervals and last for varying lengths of time. For example, economic activity hit low points in 1975, 1980, and 1982. The 1982 trough was then followed by eight years of uninterrupted expansion. For describing the swings in economic activity, therefore, most modern economists prefer the term "economic fluctuations".
Just as there is no regularity in the timing of economic fluctuations, there is no reason why fluctuations have to occur at all. Thus, predicting market timing in Real Estate is similar to planning a vacation trip to Hawaii, in January. All the brochures say the sun shines all the time but somehow, when one lands in Honolulu, he is greeted by a hurricane. Despite the fact that successful market timing may be even more difficult to predict than the weather, everyone wants to try, to some degree. Buy houses when they increase in value, and sell them when they begin to decline. Keep your cash holdings as a safe haven when you are not sure.
Regrettably, there is no guaranteed way to anticipate market movements, so attempts to clock market timing fail to deliver optimum results. And this is true of the small investor as it is for, well ... the Chairman of the Federal Reserve System. Had market participants listened to Alan Greenspan, the Maestro, when he first started talking about the dreaded real estate market bubble all the way back in December 2001, those same investors would have missed out on an appreciation of real property values that averaged 15 percent per year from 2002 through 2005 inclusive.
As much as fluctuations are difficult to predict and that, as a direct and proximate result, the market is next to impossible to be timed, fluctuations do occur, however, because there are disturbances in the economy of one sort or another. The quintessential cause of recessions and booms in real estate is monetary policy. The central banks determine the size and growth rate of the money stock and, thus, the level of interest rates. By raising or lowering interest rates, the central banks are then able to generate recessions or booms. This is the reason why keeping a close eye on interest rates is so crucial in Real Estate.
So therefore, because of the fact that fluctuations do happen, with perfect 20/20 hindsight I can tell everybody precisely when a market turnaround has occurred. Furthermore, if I look back far enough I may even see patterns to the movements of the market, which repeat themselves sufficiently often so as to convince me that they will occur again, given the same conditions, at some ‘predictable' later date. This is, in fact, the principle upon which computer programs at the Federal Reserve System work: they analyze market patterns and try to anticipate major trends to come. Computer modelling, as it is called, is employed nowadays in practically every industry. But notwithstanding all technological advances, no one has ever been able to anticipate market or economic swings with an accurate and acceptable level of consistency.
So the academic debate continues. Those who do not believe in market timing challenge not only the ability to anticipate market movements, but also the rationale behind market timing. Conversely, advocates of market timing are quick to point out that one can obviously maximize returns in a rising market and minimize losses when the market begins to decline. And in so doing, they pore over their charts and computer printouts looking for signals that the time is right to buy or sell, based upon a combination of factors that have preceded a change of market momentum in the past.
The Efficient Market Theory suggests that prices often exhibit random walk behavior, and thus cannot be predicted with consistency. In Finance, the Efficient Market Hypothesis (EMH) asserts that financial markets are "efficient", or that prices on traded assets, e.g. stocks, bonds, or real property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about future prospects. EMH, furthermore, implies that it is not possible to consistently outperform the market - appropriately adjusted for risk - by using any information that the market already knows, except through luck or - as in the case of stock markets - obtaining and trading on inside information.
And bear in mind that market timers have to be right in their predictions not once, but at least twice in a row. They also have to exit the market with consistency just before the downwards spiral begins.They have to be adept at identifying peaks and valleys as they are occurring, not after the fact. Sometimes what looks like a downturn is just a temporary resting place - as it seems more and more to be the case in Real Estate today. Also, there are those investors who simply take the contrarian approach and start buying when everybody else is selling. They then take their profits when others are busy buying.
The untold secret of real estate investing is always to buy and never to sell. That is the guaranteed path to wealth. As this, however, is not always possible, the second best alternative is to act when one's own circumstances warrant, without paying much attention to the cycles that may or may not take place.
Luigi Frascati
Real Estate Chronicle
