Saturday, February 4, 2012

Why Supply-And-Demand is Not Your Friend!

Pricing of commodities can be tracked using Control Theory.   Lately, prices for houses, gold, and dot com stocks have followed a path of unstable or runaway control systems - swinging wildly between extremes, over time.

As I noted in an earlier posting, small changes in supply and demand can cause huge swings in prices.  This can often work to your disadvantage:

For example, suppose in a mythical town there are 100 houses for sale, for $100,000 each.  101 buyers set out on Sunday to go to open houses, each buyer willing and able and wanting to buy a house.  Clearly, one buyer will go home with no signed contract for a house.  But rather than sit home and say "Well, I guess I'll just have to rent," chances are, that 101st buyer will offer $101,000 for a house, and likely snag it from a lower bidder.
The problem is, that lower bidder may, in turn, bid up another house by $1,000 or outbid the other fellow by another $1,000.  The net effect is a price war.   Since the increase in monthly mortgage payment for an additional $1,000 to $10,000 is pretty minimal, chances are, prices will escalate by at least $5,000 to $10,000 before finally one bidder says "You know what?  That's too much money for a house in this jerkwater town!  I'd rather rent" and the market finds its equilibrium price.
But note how the housing price shot up 5-10% or more in response to a 1% offset in the buyer/seller balance.  And also note how the process is reversible - if there are only 99 buyers in the marketplace, it is a buyer's market, and one home seller will end up holding on to a home he doesn't want - unless he lowers his price far enough to snag someone else's buyer - or persuade a non-buyer to become a buyer, and thus restore the buyer/seller equilibrium.

Small Changes in Supply and Demand Result in Huge Changes in Market Valuation.

We all learned about the law of supply-and-demand and Adam Smith and his invisible hand, and thought we understood it.   It makes sense, after all, if demand increases, then prices will go up, and if supply increases, prices will go down.

Where we, as consumers, get confused, is in assuming this is a linear relationship.  We think, well, the demand increases by 10% that means a 10% price increase.  And we think that if the supply increases by 10% then prices drop by 10%.

Think again.

As the example above (a thought experiment) illustrates, even a 1% change the balance between supply and demand can swing prices by 5-10% or more, particularly in the housing market, were huge price swings are muffled by 30-year amortization tables.

Throw in some "funny money" mortgages and the prices swing even more wildly.

In our Real Estate Bubble, prices went up 30% a year for a number of years, in many markets.  Did this mean there were 30% more buyers?  No, it only meant that the balance between supply and demand was off by a few percentage points, which caused the buyers to bid up prices, in order to "win" a home in a short market.

In places like South Florida, the bubble burst the same way.  A number of New Condo towers "topped out" at the same time, flooding the market with thousands of unsold condos at once.  This may represent an overstocking of housing units by only a few percentage points.  But that is all you need to start a declining price war.  If you have 100 condos and 99 buyers, then one is not getting sold, and that owner has an incentive to cut his price by 5%, 10% or even 15% to snag a buyer.

And like the rising market, once this trend starts, it takes on a life of its own, until prices are too cheap.

In Control Theory, we call this an unstable system.  In a normal system, there will be swings between extremes, but centering on a control point.   Think of your house thermostat.  You set it at 72 degrees and the furnace comes on, heats up to maybe 73 or 74, and shuts down.  The temperature drops to maybe 70 degrees and the furnace kicks on a bit, and the process repeats - in a stable system.

This mild spread in temperature, or hysteresis is not only acceptable, but desirable, as otherwise, the furnace would kick on and off continually and efficiency would suffer.   Such an overdamped system is undesirable.   Moreover, due to the large mass of the house and the air, there is a certain lead/lag effect, as the house takes time to warm up and stabilize to a temperature.

Initially, you may see a broad swing, but it tends to dampen over time until the system stabilizes around the control point.  But even then, there is a small temperature swing.

Unstable systems tend to swing more wildly.   A poorly designed control system might crank your house to 80, shut off, and then cool to 60 before coming on again.   One moment you are sweating, the next freezing.   Such systems are undesirable, of course.

A runaway system is one where things just compound each other and the system veers wildly out of control until it self-destructs.  In such a system, inputs are often opposite what they should be, and each correction just makes things worse.   Suppose you wired your thermostat backwards, so the heating control ran the air conditioner and the cooling control ran the furnace.  You set it to 72 degrees and instead of the furnace coming on, the A/C kicks in, making things colder and colder.  The system just runs away, until the house is an icebox, or your compressor fails.

Another example is a tail-happy aircraft.  A tail-heavy airplane (aft CG) for example, will oscillate wildly, as the pilot tries to control it.  But due to control reversal, his attempts to bring the nose up just make it go down, and vice-versa.    Only high-tech "fly-by-wire" systems can even attempt to tame such unstable systems.

So what is the point of all this?

Well, even in a good market, where prices are "stable", there is fluctuation, as shown above.  So prices go up and down, often amplified by supply and demand inputs.  And smart traders, who have access to better information than the overall system does, might be able to predict these ups and downs and make money in the margins.

But in an unstable market?  That's where it gets really tricky, and where people can make or lose fortunes betting on pricing.  Our housing and gold markets are unstable markets - fluctuating wildly over time - and by time, I mean years, not hours or days.

If you think about it, there is no reason a 3-bedroom, 2-bath house in South Florida was worth $250,000 in 2003 and $750,000 in 2007.   Nothing happened in the marketplace - in the supply and demand inputs - to warrant such and outcome.  It was just an unstable system, overreacting to demand inputs - wildly.

Similarly, there is nothing in the economy to warrant gold being worth three times what it was in 2005 - or $200 an ounce less than a month ago.  Prices of gold are swinging wildly in reaction to an unstable system - fed by bad data.

And that is where the system model falls apart, when applied to economics.   Your thermostat at home doesn't panic when it gets hot.  It is not afraid of getting cold.   It's isn't greedy and tries to "hoard" heat.   On the other hand, human-driven systems can be skewed through emotional inputs - poor normative cues - that drive prices up or down.

Fear is the biggie - the fear that the dollar will drop or the economy will collapse.  The Odious Glenn Beck used this to sell gold on his TeeVee show - and a lot of people, having less intelligence than a thermostat, bought gold.

And similarly, in the housing market, we were told, "Buy now or be priced out of the market forever!" which I saw as utter nonsense, as long before the housing bubble, I owned several properties, and knew that the risk of running out of homes was a specious one (hint:  They keep building more, just as they keep digging up gold).

Moreover, I knew from experience that just a few years before, there was a surplus of homes, and the demographics of the USA had not expanded to justify such pricing.

Greed plays a role too, as people hear that "everyone is making money in (real estate, gold, dot com stocks, whatever) and then they pile in, because they are afraid (FEAR again) they will "miss out" on a good deal.

A reader recently commented that he has been sitting on the fence on the Canadian housing market, but now he is afraid he will be priced out - and is thinking about buying.   How do you think that will play out?  How did it play out for people in South Florida who bought in 2007?  I fear he may jump, too late, and buy at the peak - convinced by a Real Estate Agent that a 1-bedroom condo in Vancouver will be worth a million dollars Canadian in the near future.  It won't.

Fear, Panic, Greed - the emotional inputs that distort an economic system and cause it to be unstable.

The good news is, the system is largely self-correcting.  Very rarely do systems really go runaway and crash - taking out countries, civilizations, cultures, and economic institutions.   Even the Great Depression did not take out America.  And this recession won't either - unless we give in to FEAR and let it - by skewing the inputs to our economy further.

FEAR.   Someone once said, "We have nothing to Fear but Fear itself" - and during a time of trying economic conditions.   More than just a sentiment, this was, in reality, an economic equation you could write out on a chalk board.

So, our housing market will recover.  Prices tanked - but they will level off and slowly recover, and in some markets, already are.  Hopefully, we won't see another bubble, but we said that in 1989 during the last one.  It is incumbent on US to stop letting emotions dictate our buying habits, if we want to get off this roller coaster.

And that is why I say gold will pop and go down.  Control Theory dictates this will be the case.  They keep mining the snot out of it, old ladies melt down their jewelry.   All over the world, supply increases.  Eventually, people will start to sell, as price levels off, and once that happens, it will start an avalanche of sales - a sell-off, and the little people who bought at $1700 an ounce will get screwed just as the people who bought stucco houses for $1M got screwed.

Understanding the law of supply-and-demand can help you in making investment and buying decisions.  When something is in hot demand and short supply, prices skyrocket.   That does not mean the product is still a bargain or a good buy, only that some are willing to overpay.  If you can avoid the knee-jerk reaction to buy (because supply is running out!!!) then you end up better off in the long haul.

Small Changes in Supply and Demand Result in Huge Changes in Market Valuation.