You’ll see opportunities when you know how to read between the lines.

You’ve experienced the ups, downs and lateral movements of several economic cycles. One of the lessons that longevity in the market has taught is the need to look at economic cycles dispassionately. Although real estate in the long run is a good bet, understanding where we are in the market cycle by focusing on the current numbers and trends can help you identify the best investment opportunities.

Reading the Lines

We all intuitively believe we understand cycles and have an idea of where we are in the current situation. We share opinions and personal experiences to rationalize why we won or lost our last deal—and why it‘s likely we will win our next one. The fact is, economic and real estate cycles are dynamic. We cannot predict them to perfectly time our buys and sells.

History doesn’t repeat itself exactly, although it does leave clues. If we pay attention to them, we can position ourselves to be aggressive or defensive with our real estate market bets.

Howard Marks has written a book called Mastering the Market Cycles. To borrow Marks’ words, “[T]here’s usually a line that stretches from lower left to upper right” (on a y and x axis) and “another line fluctuates up and down around it.”

Imagine Marks’ fluctuating line as a great pendulum in the sky oscillating back and forth with its center point directly above the normalized long-term economic growth line. The oscillation is caused by the sum of all market participants’ decision-making. It ultimately fuels supply and demand in the marketplace, including its excesses and corrections.

Most real estate cycle charts have home prices going up the y-axis and time across the x-axis. The same is true for U.S. economic growth charts. Historically, the data in these charts show that, over time, economies tend to grow, company profits increase, and real estate markets rise in tandem with the growth of the economy.

The fluctuating line is influenced by a plethora of factors—time of year, federal interest rate, weather, the duration of “bull” or “bear” markets, and so on—but nothing more than the sum and substance of people behind all the decision-making. The psychology of the market is utterly unpredictable.

The economic growth line has an intrinsic magnetic pull, which economists call “mean reversion.” Essentially, even with short-term shifts in the market, the pendulum will always return toward the growth line, which is the long-term average of all datasets.

The speed and force of the swing is proportional to the distance it traveled away from the line. The higher the pendulum rises above the line, the lower it will fall below the line, causing either a slight correction or a complete meltdown, as we saw in 2008.

Here’s how Marks explains the movement of the market-cycle pendulum:

• “[P]ositive events and increased profitability lead to greater enthusiasm and optimism” causing the pendulum to swing up …
• “[I]mproved psychology encourages increased activity” causing the pendulum to swing higher …
• “[T]he combination of positive psychology and increases in activity, further pushes prices higher increasing risk” causing the pendulum to swing even higher …
• “[I]nevitably this cycle takes on the appearance of being unstoppable and this appearance causes asset prices and the level of activity to go too far to be sustained” causing the pendulum to top out …
• The built-up force comes careening back toward the straight line crossing it entirely and descending into negative territory where it continues to dive until the energy caused by the excessive rise is absorbed by the corrective downs.

If you have a feel for the pendulum’s position above or below the line, you will know whether it is wise to be aggressive or to hold back.

This isn’t to suggest you try to time the real estate market, hopping in when you think it’s rising and making a quick exit when you anticipate an imminent fall. That behavior fuels the psychological herd mentality and causes extreme excesses and crushing corrections.

The best strategy is to understand generally where we are in the cycle (up or down and by relative magnitude) and adjust your aggressive/defensive behavior accordingly. Great opportunities exist in even the worst markets.

The trick is to be a first mover (aggressive buyer) when the pendulum bottoms outs and cool and calculated when the pendulum begins to peak on the upside. That’s easier said than done, even for the most experienced and dispassionate investor.

Headlines, especially those that focus on opinions rather than reporting data, reflect market psyche. Sharing this philosophy with your borrowers and investors can help them put current news and sensationalism into perspective.

Where Are We Now?

We’re near the high point. The pendulum has swung above the line and is beginning to swing the other way.

While the pace of real estate growth has slowed, prices are still rising. The pendulum is surely above the line, and it’s going to swing back. “When?” is the unanswered question. The return to equilibrium should not be consequential, because it doesn’t have enough upward momentum.

The optimism that caused the recovery is not out of hand. In fact, many would argue that we have a disciplined recovery; therefore, the velocity of the pendulum as it swings back will in no way be as disruptive as the one we experienced in 2007 and 2008.

What Should You Do?

Pay attention to the pendulum using objective and subjective indicators relative to your local market. Examples of measurable data points may be days on market and negative deviations in sale versus list price. Subjectively, pay attention to the psychology of market players. What do real estate agents report that buyers are doing and thinking? What are customers hearing at their open houses?

After a down market, how do you recognize a positive trajectory shift? Looking back at the real estate crisis, the markets began to recover in 2009. At that point, only a few determined we had hit the bottom and the market was going to recover.

Trust the Straight Line

Focusing on mean reversion can help you stay rational about the market. The straight line has a magnetic pull that will always draw the pendulum back to it. Owning real estate over many years has always been a winner.

During the last downturn, some felt we were way below the economic growth line and focused on investing capital while the market was in that position. That being said, even if you buy when the market is above the line, the economy will continue to rise. History tells us that over time, you’ll be fine.

The world is filled with opportunities if you can avoid getting dragged down by negative psychology and have the courage to be a first mover. ∞