Friday, October 06, 2006
Business cycles
Business cycles have been around as long as man has traded one thing of value
for another. Every Econ 101 student has learned about the Dutch
Tulip Craze , yet most people seem to forget the lessons learned from that
when the next big boom comes around. The 1990's produced a record period of
economic expansion and record levels for all stock market indexes. A new
paradigm was proclaimed, one where traditional business cycles were declared a
thing of the past, done in by productivity increases brought on by the
information age. Five years later, the Dow Jones has now returned to those
previous record levels, the S & P 500 still has a way to go, and the Nasdaq
continues to linger at about 50% of its highest levels. The proclaimers of the
new paradigm moved on the other things, apparently many of them getting into
real estate in Las Vegas, Miami, San Diego, coastal North Carolina and other
places. With money cheap and plentiful and stocks not looking so rosy, investors
flooded the real estate market. As with any commodity, when demand outstrips
supply, prices rise and new craze is born, and with it a new set of reasons why
this time things are different. As we are seeing now in many parts of the
country, the more things change, the more they stay the same.
Along with learning about the tulip craze in college, I also learned Le
Chatelier's principle in chemistry class. The main point here is that
systems tend toward equilibrium, and when a system is not in equilibrium, its
variables will change. Economists seem to be grasping this principle in regards
to economic systems, although it seems to have taken them a little longer than
the chemists to buy into it. What is economic equilibrium? In the stock market
it seems to be where the valuation of equities reflects the earnings those
companies actually produce. In real estate, it has to do with the value of
property actually reflecting the cost of reasonable alternatives (rents vs.
sales price being the real estate equivalent of a P/E ratio), reflecting the
percentage of people who live in an area being able to afford it and reflecting
the possibility that supply can reasonably be produced to meet an increase in
demand (the U.S is one country where population is rising, so there is a need
for an increase in housing supply, although probably not at the pace we have
seen over the past few years). In many areas, real estate markets have gotten
severely out of equilibrium and now face variables changing as those
systems work their way back toward an equilibrium state. In most cases, the
variable likely to change is sales prices, and they will have to come down in
order for the system to become equalized. Does this mean that you should not
invest in real estate. No, but it does mean that you should invest wisely and in
properties with good fundamentals. While rents are likely to rise as interest
rates go up and the excess supply of properties is worked off, don't depend on
that to make your mortgage payment. If you are buying a home to occupy, don't
buy one twice as big and expensive as you really need because you think the
appreciation on the property will far exceed the negative amortization on the
payment option, interest only loan your broker talked you in to getting. Don't
buy pre construction condos in Las Vegas or Miami or Wrightsville Beach thinking
you can double your money on a flip before they break ground.
