There
was a pivotal scene in the movie The
Matrix when Neo faced a choice. [If
you haven't seen this movie, I strongly encourage everyone to Netflix it tonight.]
Morpheus offered Neo two options - he could take the blue pill and wake up from
his dream and believe whatever he wanted, or he could take the red pill and see
how far the rabbit hole goes. Let us hold hands as we take the red pill and
dive head first.
But
first, a math lesson. Booo.
I
don't know about you, but math was not exactly my strongest subject. Math was
not my enemy, but it most definitely was not my friend. At university I was
required to take a basic statistics course. It was not the most glamorous class but I learned
some basic concepts which we need to go over first so everyone is on the same
page going forward.
Most
of the world can be described in terms of the standard distribution curve which
looks something like this:
The
best way of explaining this concept is using peoples' heights. Most men, 68% give or take, are between 5'7
and 6'0 tall. This represents one
standard deviation. The mean is somewhere around 5'7 to 5'8. When you think about it, most of the men you
know are a little taller than or a bit shorter 5'8.
About
27.6% of men are taller, 6'1-6'4, or quite short, 5'3-5'6, which is 2 standard
deviations from the mean. 95% of all men
are between 5'3 to 6'4.
About
4.2% of men are very tall, 6'5-6'7, or very short, 5'0-5'3, which is 3 standard
deviations from the mean. 99.8% of all men are from 5'0 to 6'7.
Barely
0.2% of men are in excess of 6'8 or under 5'0. They are exceptionally rare and
are 4 standard deviations from the mean.
 |
| (The numbers differ slightly depending on the source, however the principle remains the same) |
In
some countries, men's heights are a lot a shorter (or taller) and the above graph may not be
applicable. That being said, there will still be the same distribution of
heights with a mean lower or higher than 5'7-5'8.
The
point of this exercise is to illustrate that you will rarely come across
someone who is 4'8 and you will likely only come across a 7'8 man maybe once in
your life. Financial markets, IQ scores,
heights, incomes, and even real-estate pricing all fall on a standard curve
more or less. It's not a precise science, of course, but it's the best
analytical tool we got.
When
something exceeds 2 standard deviations, you know something is amiss. It just
doesn't happen often. It's rare and unlikely to repeat itself. It’s difficult
to predict when rare events happen, but we know they won’t happen often. For
example, randomly meeting two people on the subway who have an IQ of 140 on the
same day or the price of a stock increasing 35% in an afternoon - possible, but
unlikely.
You're
probably thinking, "well there are very specific factors which go into the
pricing of each asset - no two assets have the same trend line or
fundamentals." This is true. Rest assured, this blog will be addressing
fundamentals when it comes to real-estate like family income, supply, interest
rates etc., but just stick with me for a moment.
In the
real world, assets ebb and flow within a standard deviation of its trend line. It doesn't matter whether it be sugar, corn,
gold, oil, stocks, bonds, real-estate or meow mix cat food, everything follows
its trend line based on underlying fundamentals.
When an
asset increases more than two standard deviations above its trend, we will
define that as overvalued or "expensive" (I prefer not to use the
word "bubble"). Two standard deviations below, and it's undervalued
or "on sale". It's a rare event for either situation to
occur and something other than fundamentals have taken over.
When it
comes to Toronto home prices, they have increased about 5% on average for the
past 27 years or so (*long term average is about 4%*). As the graph below shows, some years were more
than 5%, others less. The graph starts
with prices declining by significant amounts in the early 1990's then reaching
a somewhat stable period for 20 years or so. However, something happened in late
2009 where growth has been consistently above 5%. What happened in 2009? Will prices
return to its trend line? What happens when an asset increases well beyond its
trend line for a long period of time? All excellent questions that will take
several blog posts to explore.
Interestingly,
as I'm sure you've read about in the media, as of March 2017, prices increased
by 33% from a year earlier or 4 standard deviations above the trend line. Was
there a hurricane that took out a big chunk out of our housing supply? Did
10,000 refugees with nothing but the clothes on their back buy up a few thousand
houses in Forest Hill and High Park? Did we stop building condos for the year?
But
most importantly, when was the last time you saw a 7'8 man on the subway?
