Tuesday, February 15, 2011

Price vs Value(or why not to read the news)

Markets are fleeting. One minute they are new and edgy giving you a status boost to the stratosphere , the next they have you left with a hefty bill, little liquidity,and a feeling of pessimism that makes you shiver at the thought of taking another chance. But they do create the chance for profit and that opportunity is a window that is eventually going to close because prices are based on perceptions not necessarily value(as anyone who lived through the dotcom boom will remember) and perception and value eventually start to come closer together.

Value is something that is underlying and fundamental to a product. It is based on more tangible and often numerical variables that and can be analyzed. Take for instance a bottle of wine. There is always a value to wine, the value you get from drinking it, but the price of a wine can change due to many underlying variables that flucuate like tastes and also I was intrigued to learn , the weather.

Orley Ashenfelter is a Princeton economist  who came up with a model for predicting the prices of bourdeux wines that was based on four important factors. His paper titled Predicting the Quality and Prices of Bordeaux Wines is available here(I'd really recommend glancing through it). The variables that he used were the vintage of the wine(year and maker), winter rainfall, summer temperatures, and harvest rainfall. Using these variables he was able to make predictions about what the best years would be(in terms of price) about what wines would fetch at the time of their maturity.His analysis was met in the wine community with harsh criticism from the tasters and magazines like the Wine Spectator, who ended up disallowing his private journal to advertise. There was an obvious clash with those who felt that their expertise was threatened if someone could essentially do more(predict with greater accuracy) while doing less(not having to sit and taste the wine every year). I bring this example up because I think it provides a really good analogy to starting to analyze the housing market and the difference between looking for factors that will help predict price movements before they happen(like Ashenfelter did) versus looking at what the housing market is doing now(like the tasters do with wine).

This post initially started as a thought I had after reading this article titled "Twin cities home values still skidding downwards" . I immediately disagreed with the title of the article because the analysis has nothing to do with home values, but everything to do with home prices. I felt like I was reading an article by a taster, not an investor. The article creates for me at least a feeling of pessimism about the housing market. I would of course have to agree with the premise of the article that  prices are going down, but that may actually increase the value of the home to a buyer(like myself).But the other thing that is tricky with markets is timing.  A taster can not taste what isn't there yet. If there is a population of people who are getting jobs now(and won't be eligible for a mortgage for 1 year) and rental prices are going to go up(but haven't gone up yet) then a "tasting" of current prices is unlikely to be seen in current housing prices(meaning there may be some future value). Information is often revealed non-linearly, which is why all markets when graphed share a characteristic self similarity. They look squiggly and have jumps like this.

So what I would like to do is find a set of adaptive variables that I can use to model future home values at rate that is better than what I can get by watching or reading the news.  I don't expect to perfectly predict the future(that would be hubris).  However like the wine in the bottle there may be shifting underlying dynamics that are based on a set of initial conditions(like the weather) that end up making the rise in home prices more predictable. I also don't intend to try to predict anything too big(like the total US housing market), but instead will try to focus on localized commutable areas like the southern twin cities using these factors. The data I will use will focus on modeling next years prices in a local area based on these factors from the previous year.

winter rental prices(makes buying more attractive to renters)
summer job market(increases number of buyers)
harvest weather(cheaper food prices)
gas /transportation prices(changes costs to buyers)

Like wine in a bottle the time to maturity may be longer than 1 year but my attempt is to use this to influence my wife and my sense of urgency to buy(if we need to have one).

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