Why do so few people understand markets?

There's an awful lot of comment in the papers and elsewhere at the moment that demonstrates how many people who are quite economically literate still don't understand markets and the way that they behave.

For instance, a number of commentators have noticed that 'affordability' criteria according to the house price / income ratio have now got back to 'normal' historical levels. Therefore, they suggest, the housing market will now stabilise.

Now, I reckon there are several things wrong with this assumption anyway.

• If I'm a first time buyer but I don't have a 25% deposit, the house price to income ratio might tell me I can afford to buy a house, but I can't get a mortgage.
  
• If I'm afraid that I'm going to lose my job, I don't care about the house price / income ratio - what I care about is the worry that the 'income' bit might turn out to be nowt rather than owt. Look at consumer confidence indices and they do not tell you that everything is going to be hunky dory.

But for me, with 15 years of market experience, the thing that's really wrong with this is the assumptions made about market behaviour. These commentators believe that markets are rational, and accurately reflect conditions in the 'real' economy.

Excretory product of the bovine herd!*

Benjamin Graham got it right when he invented 'Mr Market', the manic depressive. Markets will always tend to overreact. In a boom, property investment trusts will trade at a premium to their net assets on the basis that 'they'll be worth more next year', and houses will be gazumped. In a bust, the market overreacts in the other direction - trading every stock as if it's about to go bust, buying assets at a huge discount (because 'they might still go down'). It's like an elastic band - as every schoolkid knows, if you extend an elastic band over your forefinger and stretch it, it doesn't 'stabilise' once you release the pressure!

The housing market will not stabilise in an orderly way because houses reach their 'right' value. It is likely to overshoot considerably on the downside. Until I see houses selling on a house price to income ratio that is much less than that prevailing during most rising markets - that is in the lowest quartile previously achieved - I will not be putting funds into that market.

On the other hand, 70% discounts on commercial property stocks are making me feel modestly bullish. That discounts a further 35% fall in values this year. It will still be important to pick the right portfolios - outside the City and without too high a retail component - but I'm feeling that things might not get a lot worse. I see Hammerson is raising a rights issue, too - usually a sign of the bottom of the trough. And the yields on commercial property compare very well with other sectors - most of the true 'defensives' have been heavily overbought - so it may be time to diversify back into commercial property. (I sold all my property shares in 2005 and 2006 - a bit early, but better early than never!)

By the way, can I have a little rant about the way the words 'property market' have come to be interchangeable with 'housing market'? It is as if a major national newspaper used the word 'people' to mean only men, or 'stock market' to mean only banking shares. The property market includes office space, land, industrial buildings, and retail - which seem hardly ever to be reported on. A 12% fall in the housing market needs to be compared with a greater fall in the property market as a whole - 30% plus, according to most, already, with many trusts and property stocks trading at a 70% discount to net assets.



* bullshit