Canada's Housing Bubble

Mar 09, 2010 Musing On Greenwood

Howdy all,

Check out this article then read my brother’s scathingly brilliant analysis of the current real estate market.

He’s outdone himself this time! Wow!!!

Ethan Rabidoux 

Majority of Ontarians say buying a home is a good investment: RBC poll

The title is “Majority of Ontarians believe that real estate is a good investment”. It goes on to indicate that 90% of Ontarians believe that real estate is a great buy and a solid investment. Well, first of all, residential real estate is not an investment at all.

For a great perspective on that, please check out this month’s Canadian Business magazine, in which the cover story is titled ‘Why real estate is a bad investment’. They get it. But I digress.

Back to the prediction of the masses. Faced with such an overwhelming majority of Ontarians who would disagree with me, I suppose I should probably recant all my earlier predictions and join the party. Well, I’m not quite there yet. In fact, this only strengthens my convictions that we are at the tail end of a bull market in real estate. Allow me to explain using a couple of wonderful graphs and a brief lesson in market psychology.

One of the most amazing things about markets is that when a large majority of people believe that an investment is a sure thing, it invariably turns out to be otherwise.

Cue the first graph.

This one shows mutual fund manager cash positions in equity (stock market) mutual funds over time. It sounds intimidating, but it isn’t. The bottom squiggly line indicates the portion of the fund that is in cash at a given time. The top line shows the stock market, in this case, the SP500 out of the US.

Why is this significant?

Well, a mutual fund manager will strategically move into cash (sell stocks) when they believe that the market will go down and there will be better buying opportunities in the future. Obviously. And when they believe that stocks will go higher, they reduce their cash position (buy stocks).

What is absolutely astounding is that when taken on aggregate, mutual fund managers (who are supposed to be the smartest at picking stocks) are always holding their highest cash positions at times when the markets are about to take off, and always have the lowest cash positions at times when the market is about to tank.

In other words, they have it dead wrong virtually 100% of the time. Seriously! The vertical dashed lines make the connections for you. You see that the bottom line (cash position) is always spiked higher at times that correspond with an uptick in the top line (stock market) and vice cersa.

This is a very well studied phenomenon. For a great perspective on this as it relates to stock markets, I would suggest you read the following two books: A Random Walk Down Wall Street by Burton Malkiel, and The Little Book of Common Sense Investing by John Bogle. Both are fantastic.

The two points that must be gleaned from this are as follows:
1) Mutual fund managers aren’t worth the money you pay them. You get much better value and much better long term performance by buying an index fund.
2) As it relates to all markets, including real estate, anytime that the majority is convinced that the market is a sure thing, it will invariably do the opposite, as the majority of the money has already positioned itself accordingly. In this case, if everyone has sold to build up their cash position, no one is left to sell. That means that buying will dominate, and prices will move higher by necessity. The opposite is also true, and now is the time to make the connection with real estate. If everyone has bought expecting a higher price, then the majority of the money is already in play on the buy side, leaving the sell side to dominate the foreseeable future, with lower prices being the result of the immutable law of supply and demand.

One more graph will further illustrate the amazing effect of market psychology.

This one is kind of like the inverse of the last graph. Essentially what it shows is the stock market on the bottom (SP500 out of the US) and at the top is the percentage of the population who are ‘bullish’ on stocks. Bullish is just a term that means that you believe stocks will go up. The opposite is called being bearish.

For perspective, I am a real estate bear, while you are a misguided real estate bull. Once again, the blue line at the top indicates what percentage of the population believes that the stock market will go up. What you will notice is that, as with the last graph, points of maximum pessimism are innevitably linked to points at which the stock market is about to break out to the upside, while points of maximum optimism are always associated with periods of heightened volatility and times of downward pressure on stock prices.

Amazing isn’t it? In any market, overwhelming majorites always indicate that the opposite is about to happen, as the overwhelming majority has positioned itself (themselves?) to prosper from the ‘obvious’ coming increase in asset prices. With real estate, 90% of the population currently believes that it is a good investment (the highest in 12 years). This has translated into higher ownership rates (the highest in several generations). So the question must be asked, ‘if so many people have positioned themselves to prosper, to whom will they be selling to realize their gains’?

And that, my friends is why I am soooooooo unimpressed when I hear the talk about the massive abundance of real estate bulls out there. You should not be swayed either. The contrarians always prosper, as evidenced by the above two graphs, as well as countless academic studies on market psychology.

Public opinion will innevitably shift back to a dislike of real estate as an asset class. It will be then that I, and the other smart money, will make a move. I would advise you who may be considering a purchase to do likewise.