Markets Unplugged

When bubbles burst they follow a familiar pattern

The bursting of every asset bubble follows classic signs – as postulated by Dr John Paul Rodrique and shown in the illustration below. This has a lot in common with the typical “ABC” correction pattern which is described in Elliot Wave theory. When a bubble bursts, it generally goes through the following stages:

1) Denial (It’s not really happening – it’s only a temporary blip before the uptrend continues!)

2) Bull trap (The market turns around and rallies back towards the former high – sucking investors back into the market)

3) Return to normal (Prices almost at their former topping levels, “normality has returned to the markets” in other words)

4) Fear (The market turns around and starts falling again – people become fearful)

5) Capitulation (Reality sinks in – people then panic and the market then sells off agressively)

6) Return to the mean (Finally prices or valuations return to their mean level – or back to the mean trendline)

Phases of an asset bubble

With respect to Elliot Wave theory, when a market enters a “correction”, the pattern is what is typically called an “ABC” pattern. The correction has 3 phases:

A) The initial leg down

B) The bounce back towards (but not exceeding) the former high

C) The final leg down, taking the market below the low reached in the initial (A) leg down

Typical Elliot Wave A-B-C Corrective Pattern

NZ Housing Market is displaying the classic pattern …

The NZ housing market is displaying the classic Elliot Wave ABC pattern and also consistent with Dr John Paul Rodrique’s Bubble Bursting theory. Take a look at the below chart which shows the NZ House Price index since the peak in 2007:

NZ House Price Index From Peak in June 2007 - May 2010

There is no question that the NZ Housing Market Boom from 2000-2007 was a classic bubble. With house prices going up some years by 20-25% in a year, the same house on the same street without any modifications appreciated about 100% from the start of the Boom (or “bubble”) to the peak in 2007. This was driven by the combination of key drivers in the Property Cycle coming together to create a property Boom but also a huge market influencer was the easy and cheap availability of mortgage credit that flowed into NZ from offshore banks during this period. Without the exceptionally cheap and easily available mortgage credit we would still have had an appreciation in values but it would simply not have been so extreme.

Let’s look at the NZ housing market bubble popping process since it began in 2007 with respect to our classic ABC corrective pattern and also Dr John Paul Rodrique’s bubble popping paradigm.

A) The “Denial” phase. NZ house prices fall 10% from the peak in October 2007 to the trough in Jan 2009.

B) The “Bull Trap” followed by the “Return to Normal” phase. NZ House Prices rise to just about 3% below their October 2007 Peak. Many people believe the bust is over and the market has returned to its “normal” behaviour (rising perpetually? )

C) The Fear, Capitulation and Return-to-Mean phase. These phases have yet to come but with prices starting to fall again it looks like leg C has already begun.

The road is long with many a winding turn….

What we know about the Property Cycle is that the typical property Slump lasts at least 60% of the length (in time) of the preceding Boom – by that token NZ’s property Slump should end somewhere around the end of the year 2011 or the beginning of the year 2012. It is going to take time (at least 2 more years) for the NZ market to return to the long term trendline rate of growth which is the “Return to Mean” point in Rodrique’s chart. Note that this does not mean that nominal values will fall anywhere near their pre-boom levels – but the affordability of homes or the return on investment (measured by the rental yield of a property) may fall to pre-boom levels or within a ballpark range. Only then can buying pressure step in to propel the market into a recovery phase.

At present interest rates are rising in NZ which is going to have a dampening effect on house prices. While unemployment seems to have peaked and the situation is improving, we know from previous studies that a housing recovery always lags the bottom of the employment cycle. It does not take much for house prices to enter a downwards spiral due to the fact that house price valuations are based off what a similar house in the neighbourhood last sold for. So if your neighbour’s house gets sold at a discount to market value, then that effectively marks down all the other house prices on the same street.  This effect works to build positive momentum for house prices when the market is rising but equally can create a downwards spiral of prices when the market is weak and sellers are forced to accept lower prices.

In my opinion NZ House Prices will fall to about 10% below their 2007 peak by the end of 2011. Wages and rental yields have a long way to go yet to returning NZ’s market to normal levels of affordability for the average first time buyer, or investor. We are not out of the woods yet!