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Where Are Home Prices Headed? Just Look at the Supply

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Found the chart below on Bloomberg this morning which simply shows the median price of existing homes with the supply of existing homes overlaid. Really, this is economics 101. All one needs to do to picture where home prices are headed is hold onto this chart.

While median home prices have recovered somewhat since the low made in the teeth of the initial housing bubble unwind, and were largely unchanged in July at $182,600 compared to $183,000 in July, the months' supply of houses on the market has since exploded to 12.5 months from 8.9 months, a new cycle high.

Bloomberg economist Joseph Brusuelas notes that falling home prices "will extract a psychological toil on consumers, possibly setting of a negative feedback loop." Well, no. The sentiment is correct, but what he means is that declining prices -- which are most assuredly ahead due to the surge in housing inventories -- will set off a positive feedback loop. Let me explain, because this is something people frequently misunderstand and misstate.

When a system undergoes a disruption, a positive feedback loop will exacerbate the disruption and increase the magnitude of it. This can be expressed as follows: X produces more of Y, which in turn produces more of X. A negative feedback loop, on the other hand, occurs when something within the system acts to oppose the changes or disruptions. For example, the federal government hoped to initiate a negative feedback loop by providing a temporary federal tax credit for home buyers. That temporarily dampened the decline in sales and prices.

So, now that the tax credits have expired and inventories the rising causing prices to decline, the risk to the housing system is that a positive feedback loop develops, eventually spilling over to the general economy as consumers, as they grow accustomed to the psychology of declining real estate asset prices, come to expect declining prices more broadly, thus creating more deflation by postponing consumption to wait for lower asset prices.

POSITION:  No positions in stocks mentioned.

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