A key characteristic of free enterprise systems is the self-correcting nature of markets. Capitalism is inherently mean reverting. In other words, extremes in price tend to be self-correcting as natural market forces pull prices back to long term equilibrium levels.
There currently happen to be two important economic examples that demonstrate this profile: oil and housing. Oil prices have been moving upward at a breakneck pace for the last couple of years while housing prices have been moving lower at an unprecedented pace. While one is moving up in price and the other down, in both cases the further they move, the greater the pressure for the move to end. It is often said (but seldom believed), that the best cure for high prices is high prices. In both oil and housing, it’s tempting to project recent trends in a straight line into the future rather than recognize the natural forces that are likely to increasingly sap the power of these moves, and slow or reverse the current trend.
In the case of oil, the spectacular price move from $36 per barrel in 2004 to $75 in 2007 and recently $147 in 2008 has unleashed powerful demand and supply responses. On the demand side, gasoline demand in the U.S. is on track to decline for the first time in seventeen years as miles driven decline for the first time in nearly 30 years. Driving less can happen quickly, but a further slowdown in demand will occur over time as more fuel efficient vehicles are gradually substituted for gas guzzlers. Immediate changes in behavior are also occurring on the commercial side as airlines eliminate flights and shippers substitute fuel efficient barge and rail shipments for truck shipments. In other parts of the world where prices are controlled, such as China, India, and Malaysia, in order to ease the increasing cost of subsidizing low prices, governments have relented and raised fuel prices, and thus unleashed demand responses. Yet another long term demand response is the substitution effect as high oil prices spur investment in solar and wind power which are increasingly cost competitive with oil.
On the other side of the coin, supply responses also help put the brakes on run away prices. It takes time to bring new supply on stream, but high prices have increased U.S. oil and gas drilling to the highest level in 22 years and international activity has never been higher. The high price also makes new sources of oil viable, which is leading to huge investments in oil shale, oil sands, and liquified natural gas (LNG).
Supply and demand responses combine to put downward pressure on prices which makes extrapolating the quadrupling of prices over the last four years as dangerous an exercise as it was to make the same assumption about housing prices in 2006.
We are now on the downside of the housing price curve, but that price drop is also triggering demand and supply reactions which will eventually arrest the decline. Although, the media headlines falling new housing starts as bleak data, it’s actually very encouraging as it is the needed supply response to weak prices that is essential to restore equilibrium to the housing market. Single family housing starts in June were 647,000 units, making the second quarter the lowest level for starts since 1982, when interest rates were in the high teens. New construction is now 65% lower than at its peak in January 2006.
The underlying engine for housing demand is household formations which typically generates demand for around 1.5 million housing units per year. The current low level of construction takes pressure off the supply of homes allowing inventories of unsold homes to be absorbed by buyers. Falling prices stimulate this demand by making housing more affordable. The latest data shows affordability for the average first time buyer has improved by nearly 30% since the peak in home prices and in the 22 years of data has only been better in the winter of 1994.
This is not to suggest that the bottom is in for housing prices, but only that falling prices are sowing the seeds for that turn around as they do in all markets.