Housing Bust Opportunities

The Housing Bust Will Deliver Bargains "Learn How to Anticipate When By: Wayne Gorman, EWI's Senior Tutorial Instructor Featured in Stocks, Futures and Options Magazine, July 2007.

You only have to hear the old saying, location, location, location, once to understand why its the mantra for those who buy and sell real estate. But when it comes to analyzing real estate trends, I find that it takes more than being in the right location. It takes certain technical tools that are useful for market forecasting and for anticipating trend changes in real estate prices. Those tools are Socionomics and the Wave Principle.

Socionomics is the science of social prediction pioneered by Robert Prechter that explains that people act emotionally (rather than rationally) when it comes to investments, engaging in unconscious herding behavior. This behavior results in price trends that are patterned after the Wave Principle five waves in the direction of the larger trend, followed by three waves in the opposite direction. What makes this overall wave pattern so useful is that it has specific characteristics that repeat themselves at all time intervals, which provides a framework to identify price turning points for investing and trading.

ElliottWave.com/wave/REClubEWI

[The real estate market has shifted to center stage for traders as the recession in the U.S. housing market has weighed on overall gross domestic product in recent quarters. An important question for the economy is, will the housing sector pick up in the second half of 2007? Our author uses the Wave Principle to reveal the potential for major turning points in two key real estate sectors. Keep in mind that this type of analysis can also be used for the broader stock market, forex vehicles, commodities and individual stocks.]

Houses and Condos Are Not Shoes

The reason we can use Socionomics to evaluate real estate trends is that real estate values do not follow the basic laws of supply and demand as do mainstream purchases such as cars, shoes or computers. That's because people can be dispassionate about utilitarian goods but not about investments like stocks, bonds and real estate. (I have derived this discussion from Robert Prechter's article, The Financial/Economic Dichotomy, in the April 2004 edition of The Elliott Wave Theorist.) Simply said, when a favorite retailer discounts by 30 percent that 50-inch, 1080p, HDTV that you have been coveting, you get out the credit card to buy it. But if that nice house in a better neighborhood you have eyed drops in price by 30 percent from $300,000 to $210,000, you're more likely to think, What's wrong with it? rather than, Great, Ill buy it!

The charts in Figure 1 compare the basic supply-and-demand curves for consumer goods versus investments. Notice that for consumer goods the two curves bisect one another, whereas for investments the lines are the same. The first graph shows that when prices are high, consumers buy less, and producers supply more. When prices are low, consumers buy more, and producers supply less. In contrast, the second graph for investments shows that both the issuers (sellers) and the investors (buyers) want the price to go higher. This situation is intensified in the real estate market, where the four Bs (builders, brokers, bankers and buyers) want prices to increase all the time:

• Builders want prices higher so they can better sell their inventories of homes.
• Brokers want prices higher so they will earn more commission.
• Bankers want prices higher to protect the value of their collateral.
• Buyers want prices higher to make more money on their investments.

 

Figure 1

Source: The Elliott Wave Theorist, Elliott Wave International, www.elliottwave.com

What Depresses Housing Prices?

But since we can observe that house prices and stock prices do go down even though both buyers and sellers always want them to go up, and we know supply and demand is not the answer, what does move investment prices? Social mood.

Socionomics studies collective human social behavior and seeks to explain how human social behavior at the aggregate level results in social mood trends, which lead to changes in financial, political, and cultural trends. Its primary thesis is that people have an unconscious impulse to herd in situations of uncertainty, leading to the emergence of social mood trends (or trends in mass psychology). These social mood trends, which are reflected in data such as shares bought and sold, properties bought and sold, etc., are patterned and therefore predictable. The Wave Principle identifies the shape of the price movements and can help to anticipate turning points in price trends for the financial and real estate markets.

Want to Buy a Farm in California?

The locations adage is important when analyzing real estate investment trends in the sense that the more specific you can be about market sector and geography, the better. In other words, wave patterns in farm real estate values differ from wave patterns in prices for single-family homes and real estate investment trusts (REITs). There may also be differences from state to state as well as from city to city, much like one stock market sector differs from another.

Figure 2, a chart of California farm real estate dating back to 1910, shows a five-wave uptrend that began after 1940, followed by a three-wave downward correction after 1980, followed by the beginning of another five-wave uptrend just before 1990. This wave pattern suggests that the next price move will be either downward or sideways, as befits a fourth-wave correction.

Figure 2

To count the waves on Figure 2, its best to start from either a major bottom or top. In this case, a major bottom occurred for California farm real estate in 1942. From there, you can count five waves that lead to a major high in 1982 to complete a larger cycle wave I. The Fibonacci ratios work out well, too, since wave 2 retraces 46 percent of wave 1, close to a Fibonacci ratio of 0.5, while wave 3 equals 1.685 the length of wave 1, close to a Fibonacci multiple of 1.618. As is usual in an impulse wave, wave 3 is the strongest wave, and wave 4 makes a shallow retracement of wave 3 equal to only 32 percent. After this five-wave sequence ended in 1982, the corrective phase ended in 1988 to complete cycle wave II. The first three waves of the larger cycle wave III are already in place with waves 4 and 5 yet to come.

Because forecasting is not an exact science, its fair to point out that this price chart also presents an alternate wave count, which I have noted in parentheses. Looking at the bigger picture, its possible to count two waves into 1942, a cycle wave I that peaked in 1915 (origination point not on chart) followed by cycle wave II that bottomed in 1942. That would make the 1982 high the end of cycle wave III, and the 1988 low would mark cycle wave IV, leading to cycle wave V. In either case, whether its wave III or V, a wave 4 decline is imminent for California farm real estate, and the average value per acre should go down.

Home Prices Always Rise, Dont They?

Socionomics and the Wave Principle can explain trends in the value of house prices, too, as you can see on the next chart (Figure 3). Im sure you will recognize the price line on this chart, because it has been frequently in the news recently. Robert Shiller, economist at Yale University, gathered price data on home values from 1890 to 2006 and created what he calls the National Home Price Index. The index is adjusted for inflation and uses 1890 as the benchmark year, where the index is valued at 100.

Figure 3

One point that is difficult to miss: Up until 1997, real home values hadnt changed by very much in more than 100 years. Only after 1997 have we experienced an exponential rise in real home prices. But even more important for our analysis: This data series displays a clear Elliott wave pattern that suggests prices are near the end of either a wave III or a major five-wave advance. As with the California farmland chart, this pattern predicts that a correction in home prices is due.

My wave count starts from the major bottom in 1921. The pattern is an impulse wave, consisting of waves 1 through 5 (circled numbers), that peaks in 1979 for cycle wave I. After the corrective phase for wave II that bottoms in 1997, wave III advances into 2006. Notice that the third waves are the strongest, relative to the other waves. You can also see Ralph Nelson Elliotts guideline of alternation, where wave 2 makes a deep (sharp) retracement of wave 1, and wave 4 makes a shallow (sideways) retracement of wave 3.

What this pattern means for homebuyers and sellers is that if wave III peaked in 2006, housing prices should decline in a wave IV that will equal approximately 38 percent of the advance from the 1997 low. Thats a fairly steep drop, but I also have an alternate count (not shown on chart) that suggests that the market is still waiting for wave 5 (circled) to end. The implications of this alternate count are dramatic. If primary wave 5 peaked in 2006, completing a five-wave advance from the 1921 low, you can expect to experience an even steeper decline in the value of housing that could take us back to price levels not seen since the 1990sand possibly to levels not seen since the 1980s.

What Goes Up Must Come Down

Real estate investments are long-term affairs, and, looking at Figures 2 and 3, you can see that the Wave Principle could have helped assess major turning points in the value of California farm real estate at, say, the high in 1982 or in national home prices at the top in 1979. If nothing else, these price charts with their wave counts remind us of a most important rule: farmland and housing prices do correct after an uptrend. The beauty of having the Wave Principle at hand to study these charts is to predict when that next turn might happen.