People are not fully rational. Moreover, people’s expectations of future conditions often play as much of a role as the current situation in their willingness to buy or sell things at different prices. Keep that in mind when digesting news of gyrating prices for crude oil, gasoline and houses.
This week, the Case-Shiller index of home prices, published by Standard and Poor’s, showed that in April, prices in all 20 metropolitan areas covered by the survey were some 15 percent lower than in the same month of 2007 and down more than 21 percent from peak levels. Minneapolis-St. Paul is right in the middle of the pack, with a 15.5 percent decline from last year.
A separate Office of Federal Housing Enterprise Oversight index showed a much smaller drop, but that index excludes houses with “jumbo” and subprime mortgages, the categories showing the greatest declines.
Recent fuel price news is familiar, with average gasoline prices again hitting record levels.
While it may furnish little immediate comfort, people should remember that prices tend to overshoot, particularly when there are large swings in one direction or another.
Home prices surged 52 percent from 2003 to 2006 in the metropolitan areas covered by Case-Shiller. That was way more than any fundamental force justified. The boom became self-sustaining. As long as many people expected prices to keep going up, they were willing to buy houses.
Now they are dropping. They probably will drop below levels justified by fundamental factors. One reason they are dropping so fast is that people expect them to drop. Potential buyers thus are less willing to buy. Sellers are more willing to accept lowball offers they would have spurned even a year ago.
The same is true in oil, gasoline and diesel markets. Here expectations function through futures markets. As long as oil and gasoline prices trend upward, and many expect them to continue to rise, investors are willing to buy energy futures. This willingness to buy further boosts both futures prices and spot (or cash) prices, even when fundamental factors of production, use and stocks are little different from when crude was $70 a barrel.
The implication is that when oil and gasoline prices finally turn around, they will fall below sustainable levels. That happened after earlier oil-price crises. For example, a few years after the 1990-91 increases driven by the first Gulf War, crude prices fell to the $12-a-barrel range.
The knowledge that fuel price increases eventually will reverse may be scant comfort right now. Ditto for highly leveraged homeowners watching the value of their most important asset drop month by month. It may be months before fuel prices pass their peak and years before housing prices bottom out. But they will eventually.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.