Momentum traders and the housing market bubble

Bubbles are very difficult to recognize, by definition: you need prices to depart from fundamentals, and in the case of housing, expectations of fundamentals play the most important role. Determining whether expectations are overblown is thus quite subjective. But I think we have now a wide consensus that there has been a bubble in the housing market for several countries. The question is obviously how this could happen.

Monika Piazzesi and Martin Schneider argue that very little is required to get a bubble. A small number of so-called momentum-traders is sufficient. Using the Michigan Survey of Consumer, they find that there are always households who think is to a good idea to buy because price will rise further, but there number doubled during the bubble. They then proceed to write down a simple search model where they demonstrate that these momentum traders, even if outnumbered, have a strong impact on prices.

This is not unlike the rise of chartists on stock and currency markets who believe that future asset prices can be determined by past trends. Eventually markets started behaving in the way they were predicting once a sufficient, but not large, number of investors where following these rules. But once these self-fulfilling propecies start deviating too far from fundamentals, the markets correct themselves and get back to fundamentals. We have seen this again and again, but some people are always going to follow Mickey Mouse financial strategies, and unfortunately they seem to influence markets.