Wednesday, March 11, 2009

Playing the Game to Win

“The key link between neoclassical economics and game theory was and is rationality. Neoclassical economics is based on the assumption that human beings are absolutely rational in their economic choices. Specifically, the assumption is that each person maximizes her or his rewards -- profits, incomes, or subjective benefits -- in the circumstances that she or he faces.”
- Roger McCain Game Theory: A Nontechnical Introduction to the Analysis of Strategy

Say you are a baseball player at the plate, waiting for the next pitch. You know where you like the ball and the pitcher knows where you like the ball. And you know that he knows where you like the ball and he knows that you know that he knows where you like the ball. We could go on and on. The pitcher is going to try and put the ball where the hitter doesn’t like it but since the hitter knows this, he will attempt to guess where the pitcher is likely to place the ball to improve his chances of making contact. In a nutshell, this is Game Theory – the choices each player makes in a given situation depends in part on his knowledge of the choices available to the other participants in the same situation.

This is what is going on in the housing market and perhaps to a lesser extent, the stock market.

Housing Market
You can divide would-be home buyers into roughly two camps: rational and irrational. The housing market players who stand to benefit from buying activity (e.g., real estate agents, home builders, mortgage brokers, furniture and appliance manufacturers, etc.) are in the irrational camp because they never change their stance. (When was the last time you heard the National Association of Realtors say “Now is a bad time to buy.”? I didn’t think so.)

Rational home buyers are waiting for a better deal: lower prices, lower financing costs, bigger tax breaks, job security, etc. They are essentially applying Game Theory to their decision, in effect waiting for just the right pitch to hit with at least some knowledge of the choices the other players have available. For those that have the patience, waiting is paying off – the deals keep getting better (notice that the Stimulus Bill contained a $8,000 first-time home buyer credit that is a true tax credit, not a loan like the previous $7,500 tax “credit”. We’re also seeing more “discount model” real estate brokerages opening.).

The irrational players continue their mantra that “Now is the best time to buy” on the theory that saying it enough will make it come true. The potential buyers are hoping that they are getting in at the bottom while the other players only care about creating transactions (payday). One could argue that the transactional beneficiaries are rational in that they never change their story but I would argue that the only time the transactional players are rational is when they are laying off employees to bring their expenses in line with their expected revenues.

We’ll see the bottom in the housing market when the majority of rational would-be home buyers decide the pitch is fat enough to take a swing at it, and not before.

Stock Market
Flip to the stock market. Again, you can divide investors into rational and irrational camps. And again, the players who stand to benefit from buying activity (brokerages, banks, custodians, mass media outlets, etc.) are in the irrational camp because they never change their stance. (To test this theory, all one needs do is spend a couple of hours watching CNBC while the markets are open).

Rational investors are waiting for a better deal: lower prices (or trading the swings). Maybe this is market timing behavior, but there is so much cash sitting on the sidelines we can’t discount their patience.

Like the irrational would-be home buyers, the irrational investor camp keeps saying “The bottom is in – now is the time to buy.” These buyers have more fear of missing the up-turn than they do of losing more money by being wrong.

We’ll see the bottom in the stock market when the majority of rational investors decide the pitch is fat enough to take a swing at it, and not before.

Questions? kimm@sweetwaterinv.com

No comments: