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Tuesday, April 26, 2011

US Home Prices Drop Again



But is that bad?

In a story on CNBC, Home Prices fall for 8th straight month, David Blitzer, chairman of the Index Committee at S&P Indices, is quoted as saying, "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." When I read the same statement, I thought it was good news. Why the difference?

Everyone uses mental models in their daily life - whether they are aware of it or not. A mental model is a way of thinking, usually learned from the culture one grows up in, but often changed by education. A clear example is that in the West, most people believe that the mind/soul and body are separate. University educated individuals tend to use the scientific method to discover things, rather than logic or meditation.

Fictional character Sherlock Holmes famously uses “deductive reasoning” to solve crimes. Deductive reasoning is eliminating anything that must be false in order to find the last remaining item, which must be the truth. It is said that Sherlock Holme's author, Sir Arthur Conan Doyle, learned this technique from his university medical professor, who used it to diagnose patients.

Warren Buffett’s business partner, Charlie Munger, commonly uses “inversion.” Inversion is looking at every problem from the opposite direction from the normal one: for example, instead of asking, “How can we improve customer service?” Munger might ask, “How can we have terrible customer service?” The opposite of that answer is the way to have great customer service.

In Iraq, US soldiers and politicians often become annoyed because the Iraqis do not think of the relationship between cause-and-effect the same way we do. That is, they view the relationship between cause and effect as weak. If Iraqis take a day off to play cricket instead of building a new water pipeline, they don’t necessarily see the connection to having no clean water later that month. This difference in thinking is so frustrating for American troops that there is a whole series of military intelligence "lessons learned" documents devoted to it.

Now to examine David Blitzer’s comment: "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." Under normal circumstances, this statement would be perfectly logical. In a normal economic cycle, all these things indicate a weakening economy. David is inferring that low sales, low construction, and falling prices are bad – the traditional economist’s view. But is it truly bad? Or is David using a “fossilized mental model” – one that is not relevant for the situation?

The US had a housing bubble: that means there were unrealistic prices, oversupply, and sales to people who were not qualified. The remedy for a housing recovery is therefore lower prices, no new construction (until excess inventory is gone), and low new home sales (since foreclosures will be sold first). In other words, today's statistical weakness is exactly what the housing market needs to recover. At this point, strength in any of these numbers would be negative.

The banks can only release foreclosures onto the market at the same rate as the market is ready to absorb them. Since the banks control the flow of this inventory, new home sales and price stats are meaningless: any increase in market strength will be met by the release of foreclosures to match.

Prices are low enough that when the housing market does return, it will do so with a roar. Just like the bubble on the upside, the longer US housing numbers stay weak the more sudden and dramatic the recovery will seem.

Several months ago, I wrote that it was a good time to buy US real estate. Since then, in most cities home prices have fallen by about 3%. I do not apologize for this imperfection.

No one knows exactly when the market will recover, yet one thing is certain – buying quality real estate at a time of low interest rates and low prices will never prove to be a bad investment. Don’t try to catch the exact bottom.

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"Don't try to buy at the bottom and sell at the top. This can't be done - except by liars."

Bernard Baruch

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