Is the big rebound in housing rational? Perhaps not

Home prices have rebounded. They are up 27 percent nationwide since 2012 and even more in cities like San Francisco.  Do you worry about another bubble in the making? Not if you believe the classical efficient market theory that prices embody all available information about a particular asset, so higher home prices must reflect “new information,” even if you’re unaware of it.

But this type of thinking is half right, at best. Housing defies the efficient market theory, a hypothesis prevalent in the stock market, which does sometimes exhibit efficient behavior.

Economist Robert Shiller asserts that the housing market is much less rational than the stock market. He is co-founder of the widely watched S&P/Case-Shiller Home Price Index.

In a 2013 presentation at a convention of the American Economic Association, Edward L. Glaeser of Harvard University showed that real estate investors throughout history repeatedly have ignored the supplier response to increasing prices. In Alabama, for example, a cotton farmland boom from 1815 to 1819 ended when increased cotton production deflated land prices.

Edward M. Miller noted in a 1977 article in the Journal of Finance that a market cannot be efficient unless short  selling is possible.

In the stock market, for example, short sellers make money by betting correctly that stock prices will fall. But without short selling, smart investors who foresee price declines cannot profit from their foresight, except by avoiding investment in an unpromising asset class. And in the absence of short sellers,  little can prevent optimistic but uninformed investors from overvaluing an asset class, as happened in the housing market prior to the downturn of the late 2000s. [New York Times] – Mike Seemuth