2005-08-27 15:29:02 UTC
about human psychology and how it relates to forecasting. It's been
edited to remove where the author belabors a point or strays.
The Problem With Forecasting
Let's start with forecasting. Every few weeks I get a wonderful letter
from good friend James Montier, who is the global equity strategist of
Dresdner Kleinwort Wasserstein. James is an expert on behavioral
psychology and investing. This week's letter is lamenting the rather
poor track record of forecasting by economists and analysts.
Let me give you a summary of the paper and a few of his graphs.
"Both an enormous amount of evidence and anecdotal experience suggests
that people are very bad at forecasting. This is often because we all
tend to be massively overconfident. This begs two questions, firstly why
do we persist in forecasting despite the appalling track record? And,
more importantly, why do investors put forecasts at the heart of the
o Economists, strategists and analysts are all guilty. In general,
forecasts seem to be a lagged function of actual outcomes - adaptive
expectations dominate forecasts.
o "The two most common biases are over-optimism and overconfidence.
Overconfidence refers to a situation whereby people are surprised more
often than they expect to be. Effectively people are generally much too
sure about their ability to predict. This tendency is particularly
pronounced amongst experts. That is to say, experts are more
overconfident than lay people. This is consistent with the illusion of
knowledge driving overconfidence.
o "Several studies confirm professional investors to be particularly
overconfident. For instance, one recent study found that 68% of analysts
thought they were above average at forecasting earnings! I've found that
75% of fund managers think they are above average at their jobs.
o "Why do we persist in forecasting given such appalling track records?
There are two avenues to explore - simply put, ignorance and arrogance.
Dunning and colleagues have documented that the worst performers are
generally the most overconfident. They argue that such individuals
suffer a double curse of being unskilled and unaware of it. Dunning et
al argue that the skills needed to produce correct responses are
virtually identical to those needed to self-evaluate the potential
accuracy of responses. Hence the problem.
He gives us a number of charts showing the relationship between
forecasts and what actually happened. Let's look at two of them. What I
particularly want you to focus on is how the forecasts lag reality.
The Nobel Prize in economics in 2002 went to a psychologist, Dr. Daniel
Kahneman, who helped pioneer the field of behavioral finance. If I can
crudely summarize his brilliant work, he basically shows that investors
are irrational. But what gets him a Nobel is he shows that we are
predictably irrational. We continue to make the same mistakes over and over.
What makes for a bubble? Why do things get so out of hand? One of the
reasons is simply human behavioral psychology. The longer a trend is in
place the more confident we are in our belief that it will continue.
Especially if we are participating in the trend to our benefit, we find
all sorts of reasons that reinforce our belief that the trend will continue.
Gary North writes in today's Reality Check: "But is it a mania? This
week, I spoke with a friend who bought a 2,000 square foot house in
Orange County, California, in 1999. He paid $235,000. Two years later,
he sold it and moved out of state. He got $350,000 for it. His son, who
remained in California but did not buy a home, tells him that it just
sold for $800,000."
Let's break that down. A 30 year loan at today's jumbo rate of 5.63%
will give you payments of $4,607.78 a month. You can count on taxes,
insurance and other costs to be another $2,000. That's $80,000 a year
before you pay electricity, water, etc. or any maintenance. If your
total tax rate in California is 40%, that means you have to earn around
$10,000 a month or so (even after the mortgage interest break) just to
make you house payment.
Using a rule of thumb that says you should not buy a house with payments
that are more than 1/4 your after tax income, that means over $500,000
per year! Of course, many people are paying twice that percentage (or
more!) in housing costs in order to be able to buy a home.
(As an aside, you can buy a very nice 2,000 square feet home in Texas or
almost anywhere in middle America for $150,000. You can buy one with
some character in a very upscale community (if you can find one that
small) in the Dallas area for $250,000.)
Put simply, there are many areas of the country where even above average
income earners can simply not afford to own a home. They are being
forced to move further and further away from where their jobs are, which
is starting to really hurt a close to $3 gas in California Who is buying
these homes? And more importantly, how are they doing it?
Writing machine Robert Kiyosaki, author of the "Rich Dad/Poor Dad"
series of books recently wrote (courtesy of Gary North):
Nothing Down, Interest Only
"On Friday, June 23rd 2005, I was on Your World with Neil Cavuto on the
Fox Network. He asked me what I recommended when it came to investing in
real estate. I replied, 'If you're new to real estate investing, this is
not the time to get into the game.' Unfortunately, many people are in
the market late and not only have paid too much for their homes, they
are over-leveraged. (quoting from an article in The Economist) he went
on to say, '42% of all first time buyers and 25% of all buyers made no
down-payment on their home purchase last year.' That is what I call
over-leveraged. They bought late in the cycle, probably paid too much,
and have signed their lives away on the dotted line. I am concerned for
I read elsewhere that in some markets as high as 40% of all loans are
interest only. So we have a significant number of people who have paid
top of the market prices, have no equity in their homes and are not
doing anything to pay down the mortgage. They are betting the trend will
continue. Even though they cannot really afford the home, they believe
they will be able to sell it later for a nice profit and help them buy a
home somewhere else they can afford.
These homebuyers are making the same mistake as professional stock
analysts and economists: they are projecting recent past performance
well into the future. It is sadly part of the human condition.
One of my favorite analysts is John Bartlett, of the National Center for
Policy Analysis. He suggests that US homeowners are highly leveraged and
therefore are more vulnerable to a housing price decline. Some of the
points from his essay are sobering:
In the last four years, homeowners have taken $559 billion in equity out
of their homes. The Federal Reserve says that 16% of that money was
simply consumed (short term non-capital purchases). Cash-out
refinancings have risen to 18.1% of all refinancings, up from 7.2% in 2003.
According to the Federal Reserve, home equity has fallen to 56.3% of
real estate, down from 75% a generation ago. More and more homeowners
are buying and refinancing with unconventional loans (such as
adjustable-rate and interest-only mortgages) rather than traditional
fixed mortgages. Such loans have lower initial payments but will rise
automatically when interest rates go higher. The Federal Reserve says
that 47% of all residential mortgages by dollar volume are now
The inventory of homes in 2002 was 2,108,000 and sales were 5,631,000.
Back then that was a 4.7 month supply. But today we find an inventory of
2,751,000, but because we are buying at such a hot pace, the monthly
supply is still calculated to be almost the same.
If sales really start to slow down, then that inventory could rise very
dramatically. If a slowdown in the economy caused home sales to drop to
the level of 2002, which was not a bad year for home sales, inventory
could easily rise to 6 months or more very quickly.
Who will get hit first? Speculators in housing markets that have
borrowed with no (or little) money down at short term interest only
rates. Look around at your home town. If there are a large percentage of
homes being bought as "investment" property which could not be rented
out on a positive cash flow basis, you are probably in a bubble. You
should carefully weigh your options.
Let me speculate, despite the fact that the first part of this letter
was about the uselessness of forecasts and speculation. I think the Fed
is going to increase rates until the rampant speculation (no pun
intended) in the housing market goes away. They are going to raise rates
until housing slows down. Of course, since 40% of new jobs in the last 4
years have come from the new housing sector, and since a great deal of
the increase in new consumer spending has come from cash out financing,
this is likely to slow the economy as well. They are prepared for that.
When the housing bubble starts to deflate, when the speculators have
been put away, when the economy starts to slow and roll over into
recession, they will once again lower rates, slowly providing a prop to
the real housing market that 90% of the country participates in. That
$800,000 home in Orange County? It is going to be along time before that
house will sell at that price again once the Fed is finished. But most
of us will do just fine. And maybe we get to re-finance our homes at an
even lower rate.
What should you do if you are in a bubble area? Think about how much
equity you could get for your home today. How much income will that
money generate in a bond or CD? Look around at your rental market. If
you can rent a comparable home to what you have today for a good deal
less than what you are paying plus the income you will get from your
equity, then consider selling. My bet is you will get to buy another
property back in your area at a much lower price in a few years.
All housing bubbles have this in common. At first, people refuse to sell
at a loss (another common psychological trait). It takes a while, but as
banks start to repossess properties in your area, they will put them on
the market. Prices start to drop. Then the psychology changes. The same
human beings that thought that houses could only go up now think they
can only go down. They start waiting. Prices go lower. Inventories build.
The Fed starts lowering rates and you will get a chance to buy a home at
a lower price at interest rates lower than they are today.
By the way, I am not against buying investment real estate if you can
find properties that can offer positive cash flow. Lots of people have
made solid fortunes doing that. But I think in the coming
slowdown/recession you are going to have better opportunities to buy
investment real estate.
You have been warned.
Final thoughts: the housing bubble can go on longer than one might
think,and the Fed can raise rates more than anyone now suggest. It is
going to be a very interesting ride. Strap yourself into your seats. But
as I will re-visit in a few weeks, I still think we are in a Muddle