Every once in a while a specific blog comment will elicit a full article rather than a simple blog comment response. Recently Andy Brice from Successful Software (founder of Perfect Table Plan) wrote such a comment on my recent blog entry Manias, Panics, and Crashes: A History of Financial Crisis:
“Interesting. I’m expecting the insane UK housing market to level off or crash any time now. But I’ve been saying that for the last 5 years…”
Andy is a very smart person whose blog I regularly read (and sometimes comment on). Whose opinion I respect. In this case I absolutely agree with him. I’ve been saying the same thing for North America for some time now, as is evident even in my first month of blogging over two years ago here on FollowSteph.com.
The interesting part of his comment is that he (myself included) know just how hard it is to accurately predict a full economic shift from mania to bust. It’s easy enough to see when we’re in a mania; the fundamental economic principles no longer govern asset prices. But what’s hard is to predict when the general public will realize this. It’s just like the Tulip Bulb boom of long ago; as long as there’s a bigger “sucker” willing to pay more for the asset (in that case rare tulip bulbs) the prices are going to keep increasing.
But now comes the reality. Again it’s not possible to exactly predict when a boom or bust will actually happen, it’s easy to predict when we’re in a boom or bust phase. If the economic fundamental no longer justify the prices then we’re in for either a bust (overly priced as is today) or a boom (under priced as often happens when people overcompensate after a depression). The bigger the discrepancy the bigger the boom or bust.
The good news is that although we can’t accurately predict the exact time a bust will happen, we can still accurately predict when it’s a good time to get in and out at a profit. As Benjamin Graham expresses in his book The Intelligent Investor, as long as you’re buying your asset for less than the real value (intrinsic value) and selling it at a higher price than the real value you’re ahead. He doesn’t show you how to maximize your profit, he just helps you identify how much your asset is overpriced or under priced. No one can accurately tell you when an asset has reached its maximum price (over valuation), that’s speculating on you knowing and understanding the publics psyche which no one can do.
To put it in other words, asset (stocks, real estate, etc.) prices will always shift above and below their true economic value (known as intrinsic value). If you buy them for less than their intrinsic value you’re ahead. If you sell them for more than their intrinsic value you’re ahead. The key to investing is not to try to buy assets at their lowest price and then sell them at their highest price, no one can do this. It would be amazing if that were possible, but it’s not.
What does this all lead to? Well over time an asset can only deviate so much above or below its intrinsic (real) value before it has to re-align itself (adjust its price back to a reasonable value). Right now, at least in North America for sure, prices of real estate properties have deviated significantly above their intrinsic value, so much so that they are now correcting themselves and trying to re-adjust to their intrinsic value. And don’t think we’re there yet, they’ve still got a lot of re-adjusting to do. I expect significantly more fallout before it stabilizes. As a very basic general rule of thumb, a real estate investment property should generate you at least a yearly revenue of 10% of the purchase price (including all costs – renovations, closing costs, etc.). Right now we’re not even close to this, many properties are running at negative cash flow values! This isn’t sustainable.
Knowing this however doesn’t mean you can’t profit from the boom and bust cycles. All it means is that if you buy assets in the under priced area of the above graph and sell in the overpriced areas you should be able to consistently make profits and protect yourself. The “margin of safety” is generally considered to be the discrepancy between the actual price and the intrinsic value – that is how much the asset is under priced. The further off you from the intrinsic value you are, the bigger the profit potential and the closer you are to the max and min’s of the boom and bust cycles. Of course you need to be extremely careful the further away you are from the intrinsic value, especially for overpriced assets, because when the adjustment happens it will be faster and more volatile!
It’s possible to consistently achieve respectable profits, all you need to do is look at the intrinsic value to know when to get in and out. Although sometimes it may take years for an assets actual price to at least come back to it’s intrinsic value, it eventually does. But as Andy’s comment suggests, knowing when a market has peaked is hard to predict. He already knew that the intrinsic value was no longer aligned with the actual price of the asset (in this case real estate), but he still couldn’t know when the adjustment would occur. No one can!