A real estate market commentary with some social mood mixed in

Mr. Arries., AKA "Easy Al", (one of our less frequent contributors) was kind enough to email the following post to our blog.

The current real estate market seems to me to be the classic fear vs. greed scenario (with each having their productive place in decision-making, at times). I think Steven Saville explained it best, although he was writing about stocks. I will paraphrase and substitute real estate for this example:

if you are planning to take profits in real estate and you know that the market has a 70% probability of going higher in a year's time, should you take your profits now or wait for next year? The correct answer is: it depends on the expected magnitude of the upside relative to the downside risk. For example, if you assess that the real estate market has a 70% chance of rising 10% over the next year and a 30% chance of falling 25% then you should take the profits now.
The above question is relevant to the real estate market's current situation because although there is a reasonable chance that real estate will sell above today's levels, it does NOT look attractive from a risk/reward perspective. It could go higher, but at its current prices the downside risk exceeds the probable upside.

It seems important to factor in rates (at 40+ year lows) and household debt levels (at all-time highs both in nominal terms and in debt service as % of income). Where will the upside come from? The liquidity that has been supporting ALL markets, even those that usually run counter to one another, appears to be drying up. I would put the odds of real estate appreciation from this point forward at 50/50 at best. And even if it were to rally one more year (or two), the upside seems very limited and the downside could be devastating (have I mentioned 10 cents on the dollar?). Every successful long-term investor that IÂ’ve read about has capital preservation as the number one priority.

Of course, personal residence has consumer value to it, as well. If someone wants to live in a house for emotional reasons, then bubble-or-no-bubble it might make sense to stay in that market (but I would leverage to the hilt! Like the old saying, "If you owe the bank $1000, they have you by the balls if you owe the bank $1 million, you've got them by the balls").

P.S. On the Kerry front, I don't see him winning. Kerry has played up that he is the optimist, that things can be better. I would love to see Bush defeated, but it seems to me the social mood is growing toward pessimism and fear. The US is not looking for an optimist right now. I can envision a scenario where the economy/markets continue to decline to the election, Iraq is in no better shape, our civil liberties are being usurped, and Bush STILL wins. It occurred to me the other day that perhaps there is another election snafu (electronic voting, maybe?) that sows the seeds for future acceptance of a different form of government. OK, I'm done.

Sincerely,

Mr. Arries