The Nature of Market Reversals

When I wrote Houses Should Not Be a Commodity, I wrote extensively about the psychology of the market and the dynamics which cause prices to rise and fall. Nothing I wrote was new or original.

I have been reading The Disciplined Trader by Mark Douglas. I came across the passage below on pages 199-200:

The reason why a bull market is ready to tum into a bear market when the general public gets involved is because the general public has the least tolerance for risk and consequently needs the most reassurance and confirmation that what they are doing is a sure thing. As a result, they will be the last to be convinced that the rising market represents an opportunity. If a bull market has lasted for any length of time, the general public will feel compelled to jump on the bandwagon so to speak, because of their perception that everyone else is doing it and making money. They will pick up on any reason that sounds the most rational to justify their participation, when in reality, they will know very little about what they are doing, but since everyone else is doing it, how can they go wrong.

A continuing bull market requires the continual infusion of new traders who are willing to pay higher and higher prices. The longer a bull market lasts, the greater the number of people who are already participating as buyers, leaving fewer and fewer traders who haven’t already bought and fewer and fewer traders who are willing to bid the price up. These older buyers obviously want to see the market keep on going up, but they also don’t want to get caught holding the bag, if the market stops going up. As their profits accumulate from the higher prices, they start to get nervous about taking their profits.

By the time the general public starts buying en masse, the professional traders knows the end is near. How does the professional know this? Because the professional knows that there is a practical limit to the number of people who will participate to bid the price up. There will come a point where everyone who is likely to be a buyer will have already bought, quite literally leaving no one else to buy. The professional trader would like the market to continue to go up indefinitely just like all the other buyers. However, he also understands the impracticality of that happening, so he starts taking his profits while there are still some buyers available to sell to. When the last buyer has bought, the market has no place to go but down.

The public gets stuck because they weren’t willing to take the risk when there was still potential for the market to move. For the market to sustain itself, it needs to attract more and more people. As big as this country is or the world for that matter, there are only so many people who will buy. Eventually the supply of buyers runs out, and when it does the market falls like a rock.

The professionals have been selling out their positions before this happens, but once the supply of buyers runs out, the professionals start to compete among one another for the available supply of buyers which is dwindling fast, so they offer lower and lower prices to attract someone into the market so they can get out. At some point, instead of the lower prices being attractive to people, it panics them. The public didn’t anticipate losing. Their expectations are very high with very little toleration for disappointment. The only reason they got in was because it was a sure thing. When the public starts to sell, it starts a stampede.

Again, people will ascribe their actions to some rational reason because nobody wants to be thought of as irrational and panic stricken. The real reason why people panicked and the prices fell is simply because prices didn’t keep on going up.

Do you see the parallels between the behavior of our housing market and the description above?

10 thoughts on “The Nature of Market Reversals”

  1. awgee

    I keep reading posts saying that once re prices come down a bit, folks will start buying because they will pereceive the prices as more reasonable or a bargain. This is just wishful thinking, not based in factual history.

    If you understand the above information and apply the information to the sell side of the equation, you will realize that as prices go down, folks are less willing to buy, and prices fall farther and faster as a result. The crowd is afraid to buy because they do not know the true value of the asset, and only see the price and price movement.

    The reversal comes when the knowledgeable investors, (professional traders), who know the actual value of the asset relative to other assets and income, start buying. Usually, this is when the general public decides the asset in question is a terrible investment.
    —–

  2. IrvineRenter

    Your analysis is “right on” as usual. The falling prices = bargain theory is nonsense, and I really want people to see that. I hope more of the general public reading posts like this will change their thinking and not become bagholders.

  3. Jwm in SD

    That may be wishful thinking IR. I agree with everything you’ve said and have applied the stock market analogy myself. However, you will get a lot trolls posting here on how the RE market is not analogous to the Stock market….why, “because people live in their house and not their stock”. Another strawman argument will be that RE is not as liquid as a stock. I think both sides are right actually depending on their perspective.

    The only differences I see really between the RE Market dynamics and the Stock market dynamics is the timeframe over which the trends manifest. It’s obviously much faster in the stock market….but an asset is an asset is an asset. Which one would you rather have right now?? One you can sell with a mouse click or one that might take several months???

    A lot of people in SoCal are in for a rude surprise over the next several years. Specifically in OC.

  4. IrvineRenter

    “The only differences I see really between the RE Market dynamics and the Stock market dynamics is the timeframe over which the trends manifest.”

    I totally agree with this statement for the reasons you mentioned.

    I hope I am not engaging in wishful thinking. Several people have posted in our forum that we have saved them from making a bad purchase; although, I am afraid for the majority, you are right…

  5. Jwm in SD

    Probably true for the majority. I see it being the same thing that made J6Pck think he could be a daytrader back in the late nineties early 2000. He quickly figured out that he couldn’t do and lost his ass.

  6. Irvine Soul Brother

    What about when housing markets drop? Is there a known trend about the speed of a drop compared to the speed of the run up? Is one historically steeper than the other? By these arguments, it seems as though drops would occurs steeper. Is this line of inquiry too general, or is there a trend in this respect?

  7. SoCalWatcher

    That book excerpt is absolutely accurate, spot on, correct as can be. Amazing how greed and visions of Ben Franklins dancing in people’s heads clouds any rational due diligence when making a large purchase like a home or an investment property.

    I am sure many got lucky and made a killing with little effort and lack of knowledge about what they were doing. The ones who go killed are the ones who will learn the business the hard way. I wonder how many of these instant housing millionaires who got lucky will get burned the next time they try to ride a wave and drown?

  8. Jwm in SD

    A lot of them most likely re-invested in 05 and 06 when it wasn’t abundantly clear that the bubble was going to burst.

  9. Beinformed

    To irvinerRenter, I enjoy your blog page and I agree with everything you state in it. I just thought you would like to also know that according to the MLS listing site (where all the supposedly legit homes for sale are put by realtors) states in RED and at the beginning of the site that ALL HOMES TO BE LISTED ON LIST SITE MUST HAVE A PHOTO, and I guess the MLS knew that realtors love caps! But my question is why are some realtors still not obeying this rule?

    Beinformed

  10. Sue

    Survey finds optimism among homeowners
    STAFF REPORT

    A survey by Attorneys’ Title Insurance Fund suggests that the current Florida real estate market is rather Dickensian.

    http://www.heraldtribune.com/article/20070814/REALESTATE/708140607

    A survey by Attorneys’ Title Insurance Fund suggests that the current Florida real estate market is rather Dickensian.

    The best of times: 63 percent of the 1,415 Florida homeowners surveyed by the big title insurance underwriter expect that the value of homes in their community will remain the same or rise in the next 12 months. Thirty-six percent think prices will rise, 37 percent that they will fall and 27 that they will stay the same.

    The worst of times: 80 percent agreed that now is a bad time to be selling a home and worry about their ability to sell their property if they needed to.

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