|
Page 1 of 2
There are many theories about why markets go up and down and become dramatically overvalued or undervalued. There are cycles of greed followed by fear that often explain the huge  variations in valuation. Take for instance the recent boom and collosal bust in housing. While academics tried to explain housing price increases based on demographic factors, we all know that the "jump on the bandwagon" factor and greed had far more to do with it. And only irrational fear can explain why massive government incentives, low interest rates and decade-low prices have failed to stem the decline in housing prices.
Why are so many people who where frozen out of the housing market during the bubble still sitting on the sidelines rather than doing a few logical calculations on the cost of owning versus renting. One theory I like is what's refered to as the "Strong Hands - Weak Hands" view of the market that became popular during the 1930s stock market crash. If you understand the theory, you'll understand why most of the gibberish that you hear on CNBC and other mass media outlets is dead wrong.
So what are "Strong Hands?" Put simply, they are those investors that can make investments in turbulent times. They have the resources to invest when few are willing to put money up and they are the ones that can either exit or stay the course when things go badly. They also have the discipline to run a logical model for their investments. "Weak hands" on the other hand are those investors that are fickle and lack the resources and fortitude to last out a downturn. They are often inexperienced in the areas that they invest in and rely on illogical arguments as to why they will make or lose money.
Accumulation:
Let's turn back to our real estate example. Back in 1998, we were only about 4 years out of the last downturn, the economy was doing well, and interest rates were high, about 8 percent. Getting a loan was fairly difficult and real estate prices were still fairly low nationwide. With fresh memories of the beating others took in the recession of the early 90s and the housing collapse that hit hard in the Northeast and the West Coast, many people shunned real estate. I had friends that would talk about houses one block from the beach in California that nobody wanted to touch. During much of the mid to late 90s, the Strong Hands went to work, snapping up properties at huge discounts to their intrinsic value based on rental equivalents and replacement cost. They took note that the improving economy was driving down vacancy rates. Nobody talked much about real estate at that time, because it was boring, and the Strong Hands were more than happy to keep their mouths shut.
Wider Participation:
At some point, a broader group of people started to notice that real estate was faring much better and the cycle of fear began to ebb. Annual increases of 5% to 10% started a new round of optimism that good returns could be had by investing in real estate. Most of these people fell in the middle, neither strong nor weak. By 2002, this middle group gradually entered the market which led to a substantial reduction in available inventory. In some areas, that resulted in scarcity and panic buying with some houses selling the day they were listed and multiple offers being made on certain properties.
Eventually, real estate fared so well, that a broader group of people began to enter the market - the Weak Hands. They invested, not because of any fundamental analysis but because they were lured by wild eyed stories about people making fortunes flipping real estate. By 2004, the Weak Hands started snapping up properties at a record pace fueled by zero down financing that required minimal, if any qualifications. They paid higher and higher prices with the justification that some other fool would come along and buy their property at an even higher price. The Strong Hands started noticing a problem - there was no possible justification for the alarming increase in housing prices. They had purchased their positive cash flow rental properties at prices that were seven times the multiple of annual rents and now the same properties where valued at 15 times the annual rent even though rents had increased 30%.
|
