Downside expectations and market effects

An interesting thing happened to me the other day, as I was looking a an open house (not browsing to buy, just browsing for home ideas). I struck up a conversation with the RE agent there, who was eager to convince me that it really is the right time to buy (like it always it, of course, when you're in sales). Amidst the usual baseless arguments, prognostications, and typical sales speak, there was the familiar argument: nobody can know which way the market is going to go, so you shouldn't hold off buying because you think the market is going down (I'll call this "the argument"). I was struck with the significance of both the argument itself, and the current state of the market, and how there are some interesting effects going on.

First, in a normally performing market, the argument makes sense, and is almost a tautology. In normal free markets, the valuation of traded commodities is based on the weighted average of the future expected value of the commodity. The weighting is both in terms of amount of value in the market (the more of a commodity you own, the more your perception influences the price), and the time horizon of the expected future value (the further out your horizon, the less certain your estimate, and the less far from the current price you're willing to trade on). As perceptions of the future value changes (eg: news, events, natural effects, etc.), the value of the commodities changes to reflect the new perceptions. This is true for virtually all free traded market assets: stocks, commodities, derivatives, real estate, etc. If the weighted average perception was that the future value was going to be higher or lower, the immediate value would change to reflect it, restoring the validity of the argument.

Now consider the housing market, which is going through a strange period. There's a glut of inventory, and prices will typically fall when there's an over-supply compared to demand (simple economics). In addition, there's a large "shadow" inventory of REO properties held off-market by banks currently, which contributes to the perception among the educated would-be market participants that there is even more downside potential (from excess supply) than the market is currently priced for. Also, there is a large ($3+ Trillion) amount of so-called Alt-A mortgages adjusting in the next few years, most of which will default once they do (but probably not before), which will create more supply at that time. In addition to that, there are various government efforts to postpone and/or delay foreclosure efforts from lenders, which delays more REO entries onto the market, building in more delayed downside expectations from additional inventory. And all of these are before we consider the various loan modification programs, almost all of which provide a delay for defaulting, but almost all of which will eventually default again (indeed, over 50% do within 6 months).

All of these factors contribute to pending downside expectations among educated would-be market participants. Until these events are all realized into and through the market, there will continue to be very justifiable reasons for thinking the market is going to go down in the near to medium term, rendering the argument inaccurate. Moreover, everything else the government does to stall inevitable foreclosures and bank failures contributes to the problem: it's easy to subsidize the failed borrower or lender for a few more months, but everybody knows eventually they will fail, and the properties will go onto the market, which creates more downside expectations. Indeed, not only can you have an idea which way the market will go, you can be almost certain, and have your view reinforced with every passing day and new bailout debacle.

This, in turn, creates a strong disincentive to participate in the market (at least in a buying capacity) as long as the downside expectations persist, which is bad news for anyone in the RE industry now (as most of them could already tell). I would venture to guess, however, that most people in the RE industry are not as aware that everything the government is doing to "help" is having the unintended? consequence of hurting them and the market further, by creating additional downside expectations. When will it stop? When the validity of the argument is restored, of course, which cannot happen until there are equal upside expectations to match the downside ones. With an oncoming recession, pending massive job losses, a socialistic government response, and the government "help" so far, I wouldn't hold my breath; it's going to get very rough in the Obamanation.