Monday, April 2, 2018

How Reddit post got me thinking on speculative pricing of assets

I recently came across this reddit post --  someone with $310K income asking about whether they should try to buy $800K condo with 1 bed, 1 bath in San Francisco. Now $800K is the asking price which probably means that people will bid it up another 10%-20% because that's the "norm".

Two things caught my eye in this post:
1. The carrying costs of this condo (interest, property taxes, HOA fees) will be ~$4K / month, which is higher than renting an equivalent apartment ($3.2K - $3.6K) in the same SOMA area in San Francisco. Clearly its cheaper to rent vs buy, but probably the fear of being priced out in the future is driving this person's actions.
2. This person has close to 14% of their net worth in cryptocurrency!

Could this Reddit posting person be recycling capital from the good ($310K combined salary, presumably from tech) into the speculative ($800K for 1 bed / 1 bath condo, $45K in cyptocurrency)? Probably they're trying to get "fast appreciation of assets" to buy that 1000 sq ft $2.5M Palo Alto home 10 years down the road.

Could this be a speculative episode justified by housing shortage, tech riches (currently), and fear of missing out if not acted immediately?

What are the conditions for a speculative high pricing of assets?

I turned to John Kenneth Galbraith's A Short History of Financial Euphoria for some answers. Galbraith says that speculative episodes are caused by  people either thinking this time is different (due to new technology or new opportunity), or they think that they are smart enough to get out before the speculation dies (they won't be the last fool holding the asset).Another theme in Galbraith's book is that progress in finance is cyclical - there is no permanent high plateau. And the gap between the cycles is ~20 years because the memories of the old bubble are lost in that period.

Based on Galbraith's description, these might be potential candidates for speculative pricing :

1. Technology ETFs

I hear these two things a lot here in Silicon Valley -

a. This is a new dawn, tech will do great as investment regardless of valuation (insert some buzzword here like AI, or machine learning, or self driving)
b. ETFs are the way to go, and there's almost universal consensus that human investors underperform the market. Even better if there's an app to invest one's money ("automate, why do the hard work yourself?")

There's lot of conversation around FAANGs that sounds similar to Nifty Fifty from 1970s. Nifty fifty were fast growing companies (McDonald's, IBM, Texas Instruments, Digital Equipment Corp, Coca-Cola, etc)  that were considered a buy at any pricing (price being 42 times earning at the peak), before losing 2/3rd of their price in the crash from 1972 to 1975.  Here's a good article on Nifty Fifty.

FAANGs are no doubt great companies  (i.e. have great products), but are the valuations too rich?

2. Bitcoin / cryptocurrency

It has all the ingredients for a bubble : Shady operators, unregulated markets, product without intrinsic value, your cousin telling you why you ought to buy it.

See the chart below and here's the accompanying writeup on why Bitcoin might be a bubble.


3. Housing cost in big cities

The SF condo post from Reddit highlights how renting is cheaper than buying. But SF is hardly the only city that has speculative pricing for houses. A recent FT article showed how house prices in all major cities in the world rose rapidly and in unison after the 2008 crash. Global low interest rates were cited as the cause, along with flight to safety for foreign (read Chinese) capital into real estate in "global cities".  As James Grant says, low interest rates lead to mispricing of capital and credit, and thereby mispricing of risk.

The most interesting case in terms of real estate speculation seems to be Toronto. Toronto Star archives paint a scary picture of the 1990s Toronto housing bubble - some examples being a penthouse sold for $299,000 in 1991 when a couple of years ago it would have reaped $450,000 to $495,000. There was also story of elderly man buying 3 condos with his $300K retirement and losing it. Sounds like people stretched too much to buy house that they could not afford.

And now in 2018, some similar things are repeating in Toronto - buyers are walking away from signed deals, and some are selling houses at steep losses within an year, see the tweet example below (h/t @ExtraGuac4Me). Another example was when @catosletters heard a CIBC bank teller telling him that she bought a second condo and rented it back to previous owner!  Even back in 2015, Mr Money Mustache showed how renting in Toronto was way cheaper than buying. Could this be a repeat of 1990s since 20 years have passed and the memories of the previous crash have faded?


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