Monday, September 19, 2011

Bid-ask spreads and rational markets respective to Real Estate

Efficient markets are “rational.” The Efficient Market Hypothesis (EMH) is a concept that most can nod their head in agreement towards regardless of a genuine understanding of the phenomenon. So I have recently been pondering: is the housing market today a rational one? I tend to think negatively, and here is why…

The bid-ask spreads are most revealing: what a willing buyer and seller come to terms on with prices, ignoring all commissions. Generally speaking, narrow(ing) spreads equate to efficient, liquid market environments. Liquid and efficient markets foster trust, faith and stability. Today’s housing market has spreads that easily exceed 10-20-30%! It is not uncommon to purchase a home at discount prices of…well you know what I mean.

So, let’s think about the concept here—a buyer’s market is not a seller’s market, and vice-versa. That is just another way of saying which of the two parties is facing more of the pressure to compress the bid-ask spread: will bids come down or asking prices go up? Today is more on the irrational side because of the psychological bias that sellers more notably are dealing with – denying what willing buyers are willing to pay. 

This is significant because as far as I see it, if spreads continue to remain as wide as they are…it justifies that the housing market needs more time to stabilize itself. Unfortunately, prices tend to stabilize in the downward direction more than upward (funny thought). Much of the dislocation comes as a function of the price-appreciation component of Total Return concept. If homes are perceived to no longer offer greater appreciation than the long-term rate of inflation, 3 percent per year, then that will definitely prove that the pressure should continue to be on sellers to narrow the spread.