I want to demonstrate from a technical analytical point of view why graphs can point the way to possible large house price declines.
The tendency of all markets whether it is in stocks, bonds, currencies, art, pork bellies or real estate is that the prices tend to over shoot to the upside, in a bull market, and conversely they overshoot to the downside in a bear market. However, in any cycle the tendency is that prices will revert to the mean, or some point which can be quantified by the average. That could be a mean reversion line, a simple moving average, or an exponential moving average. The point is that prices will snap back to the mean in the end, the way the mean is measured is not always important.
This phenomenon when markets overshoot then pass through the mean on the way to the downside before coming back to the mean again is repeated thousands of times every day in all stock exchanges of the world, commodity exchanges, bond markets, etc etc…let me explain how this takes place on a daily basis.
One of the more poetic characteristics of market charts is the endless flow of expanding and contracting patterns that are formed by an ever changing flow of supply and demand. What is most striking about these patterns is that the same patterns are repeated in the same manner regardless of what timeframe.
Have a look at the three charts below. I have removed the price and time axis. They are currency charts for GBP/USD. All three charts contain very similar characteristics. The red/pink centre line is a 30 period simple moving average. The outer lines one below and one above the centre line that are expanding and contracting are measurements showing when price moves 2.5 standard deviations away from the 30 period simple moving average line.
You can see by looking at the charts that price tends to move across the centre average line, reaches the extreme band (2.5 standard deviations), stays there for a while and then turns around and heads back towards the mean, and more often than not moves through the mean average line to the other outer line.
This prevalent characteristic is played out continually in all markets and in all time frames. The reasons for this phenomenon will be explained in another follow up article.
Continued below charts….
Chart 1
Chart 2
Chart 3
Have a look again at the three charts. The price movement in chart 1 from right to left takes place over a 2hour time frame. In chart two the timeframe from right to left is about 10 days, and in chart 3 the timeframe is about 7 years. The same characteristic of mean reversion and trend reversals takes place at all time levels and the law is unfailing.
On a longer time frame of course it will take months and years for price to mean revert, but at some point this will occur.
Now at this point you are probably wondering what this has to do with house prices? Why do I forecast a potential technical signal pointing towards house price declines of 30% to 50%? In short the answer is related to the characteristic explained above that all markets indeed correct and head back to mean reversion. The evidence is overwhelmingly in favour of a correction in the UK housing market. It is fool hardy to ignore history. In the words of Mark Twain, “history never repeats exactly but it certainly rhymes” are wise words to heed at this time. I’ll now show why those words of wisdom should be at least given some attention at this time…
Again, take a look at the average UK home prices since 1978 measured against the exponential mean line. I have numbered the pivotal turning points 1-7 during this period. I might add that the size of a bust is usually somewhat proportional to the size of the preceding boom.
At point (1) house prices took off to the upside before mean reversion and an over shoot to the downside brought house prices down 25%, point (2)
The bottoming out of house prices occurred during the years 1982-1984 and led into another house price upswing with a 100% increase until the peak at the end of the 1980’s. This led to a house price collapse where prices fell through the mean reversion line and bottomed out in 1996 after a 50% fall from the preceding peak, point (5)
Between points (5) and (6) a 12 year boom in house prices occurred, stretching prices far from the mean. This was an unprecedented rise in house prices, similar in magnitude to the Japanese real estate boom in the 1980’s which led to a 50% deflation in prices over 14 years. In Japan the nineties is known as the lost decade.
We are now currently at point (6) and prices in recent months have turned around and are now heading down. Following the logic that all markets, whether that be stocks, bonds, art, metals, and real estate in all time frames revert to some kind of average, it is no way a radical thought to suggest house prices could drop 50%. However, suggesting this to the vested interest groups leads to call accusations of heresy.
The other characteristic that was mentioned is the tendency of markets to overshoot on upside and the downside. If we use the daily occurrences in markets and history as a guide, it is fair claim that house prices in the next five, six, seven years could bottom out at 50% percent below the climatic peaks reached in the summer of 2007. At point (7) I have extrapolated the red line along the same trajectory prices are on now. As can be seen this would mean a minimum of 25% falls by the end of 2009. However, as is usually the case I would not rule out prices dropping to near pre boom days, perhaps, where prices were in 2000-2001. That would be nearly a 50% correction.
I also believe that the buy to let and new builds market which really took off after 2005 could experience deflation of between 50-60%.
Another point worth mentioning is that more often than not when prices do turn around, and the trend changes, that sets in motion a longer term trend. What I’m trying to say, is that once some structural changes take place and a trend reversal occurs, this is not likely to be a blip in the main trend, but a longer term sustained change. I would note that the structural change that has taken place in the last 8 months is one of credit deflation. Banks are no longer willing to provide credit. As real estate is the biggest credit backed asset most people take on in their lives, then it stands to sense that a credit contraction will lead to a real estate deflation.
How does this translate into investment advice?
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