Wednesday, May 30, 2007

Pop Goes the Bubble...

What do bubbles look like when they burst? That all depends on the characteristics of the market with the bubble. Sometimes it may burst quickly, like a balloon, and other times it may takes months or even years to correct.

The reason for this is that bubbles develop when market expectations of future prices de-couple from market fundamentals. Bubbles burst when those expectations change. Changes in expectations depend on the flow of information, and this varies with the market.

Take, for example, the housing market in the US. This bubble is bursting as I write.... but slowly. The latest figures show that home prices declined 1.4% in the 12 months ending March 31. How could such a small price decline represent a bursting bubble?

One key feature of housing (especially outside of Hong Kong high rises) is that houses are unique. As a result, they are highly illiquid- a sale depends on a match between a prospective buyer and seller, and few buyers will simply buy the first house they see. Matching takes time, so the market is sluggish. That sluggishness translates into information flowing slowly through the housing market, and sluggish expectations.

Uniqueness also makes determining the price more difficult. Any two houses are likely to differ along many dimensions, so even if you think that equilibrium prices may have fallen, any fall is small relative to the overall price variation between houses. Yes, average prices may have fallen by 1.4%, but the most desirable houses in a neighbourhood still sell for a price that is a multiple of the least desirable. Paying attention to the differences between houses is far more important to the individual buyer or seller than paying attention to movement in the average price.

Additional sluggishness stems from uncertainty. At times like this, many potential buyers may simply stay away from the market because they do not know which direction the price is going, reducing the number of sales that take place. Fewer sales imply less information and slower learning.

Where these information asymmetries are partially alleviated, the collapse of the bubble may be faster. For example, the price of new homes in the US dropped 11% over the past year, and some home builders expect the market to take until 2011 to recover. What's the difference between the new home sector and the second hand market? The former is dominated by larger players, selling many homes, with similar characteristics, while the latter is mostly individuals selling a single unit. The former therefore have a much better idea of the overall direction of the market. They were faster to cut prices as they recognised the change in trend. I expect that second hand homes will follow new homes down in price, perhaps by a similar magnitude, although it is not yet clear that even the new home market has bottomed out.

Equities are a stark contrast from homes. They're liquid, generic, and price is public knowledge. Up until the latest house price data was released, various analysts were speculating on what the price of housing was in the previous month! In comparison, no one has any doubt as to what the price of shares was just a few minutes ago. So when the market does change, expectations adapt quickly. Participants rapidly adjust their positions, and the market adjustment continues. This process is further exsacerbated by "stop-loss" orders, where investors can agree to sell their holdings automatically if the price falls below some pre-set limit. Clearly it's impossible to have a stop-loss order on your house!

For more on the US housing market, Calculated Risk has some excellent analysis on all the latest numbers. See also Nouriel Roubini's blog

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