Robert Shiller wins Nobel Prize for explaining asset prices

How does one know where asset prices are headed?

It was answering this question that recently won the Nobel Memorial Prize in Economic Sciences for three American economists.

Robert Shiller, co-founder of the Case-Shiller Home Price Index, Eugene F. Fama and Lars Peter Hansen are the three Americans sharing the prize.

Fama’s work in the 1960s found that it is impossible to accurately predict which direction asset prices will head in the short-term. However, Fama asserted that long-term price trends can be predicted with the help of price indices.

On the other hand, Shiller’s more recent work asserts that markets are driven by the irrational behavior of consumers. For an example, Shiller has written that the housing bubble during the Millennium Boom was caused by a period of high optimism that home prices would continue to increase indefinitely. Shiller also predicted early on that the bubble would soon burst, a theory made famous in the second edition of his book, Irrational Exuberance (a term coined by former Federal Reserve Chair, Alan Greenspan from conversations with Shiller).

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first tuesday insight

Shiller’s main contribution to the bank of real estate understanding, simply put, is that bubbles are inevitable. But they are not necessary. Price bubbles are not generated by a mad crowd blindly and feverishly bidding real estate prices through the ceiling.

Rather, they come from individuals making buy/sell decisions that seem reasonable to them, but are in fact based on misunderstandings, myths and societal pressures (read: the American Dream mantra).

The broader implication here is that the history of unsustainable real estate market bubbles can be undone with education. To this end, first tuesday makes the effort.

Given the complex structure of real estate prices that Shiller has pointed out, it’s clear there is no magical, mathematical formula for predicting where the market will go. However, a mix of economic models, historical and cultural understanding can point investors to the likeliest way asset prices will move in the coming months and even years.

First, short-term price movement is the most volatile and thus most difficult to predict with any degree of certainty. Home prices vary from month to month. However, trends take shape over many months.

These trends are based on a variety of factors, including:

home sales volume during the preceding 12 months;
the multiple listing service (MLS) inventory of homes on the market, including newly constructed homes;
buyer incomes and mortgage rates, which collectively make up buyer purchasing power;
movement in the yield spread, consisting of bond market confidence and action by the Federal Reserve (the Fed); and
a bit of that irrational human behavior – animal spirits – that pushes on all asset prices, as described by Robert Shiller.

The situation for home prices going into 2014 is a bit of an anomaly. Prices have been pulled sky-high by speculator interference (a case of classic irrationalism in the market). Unlike during the Millennium Boom when the availability of subprime financing allowed end-users to compete, incomes and available financing today are serving as a firewall against a comparable bubble. This is especially true when the financial situation of the average end user is met with today’s increasing mortgage rates and home prices.

This, along with the level to downward trend in home sales volume experienced in 2013, will flatten home prices by year’s end. The speculator anomaly, like all bubbles, can’t beat larger mean price trends.