The FOMO premium

Posted by Gavin Chau

This week we’re going to have a look at the effect of FOMO on market prices. Often referred to as “animal spirits” in Keynesian economics, it refers to the effect of human emotions on consumer confidence and asset market valuations. The term comes from the Latin spiritus animalis, meaning “the breath that awakens the human mind,” which sounds much more serious and intellectual than FOMO. Keynes’s use of the term was probably the first official recognition of psychology’s effect on asset market valuations and the proto-form of modern behavioural economics.

Market prices are typically set by people’s intuition and the behaviour of other market participants rather than on solid analysis. As such, they can run higher or lower than a technical fair market price – often for long periods of time. This is typically exacerbated by the over-involvement of central banks through the manipulation of the money supply, which throws markets out of equilibrium. Nevertheless, the market always returns to its fair value over the long run. These over and undervaluation periods give market cycles their shape over time, and strangely enough, this can even begin to shape the physical environment around us.

Most recently, we can see the FOMO effect in the property market following the credit-driven price boom as the cash rate dropped to 0.1% and RBA began its first-ever QE program. The excess capital flowed into asset prices as it always does, pumping them briefly past their fair market valuation. They have since fallen back as interest rates have been raised in order to combat the threat of runaway inflation. First, let’s look at what might constitute an asset’s fair market value to get a sense of where we are.

We can split assets into network adoption assets and mean reversion assets. Property is a mean reversion asset that tends to either overshoot or undershoot, but in the long run, it always reverts to the mean. This is clear enough when we run exponential regression analysis on the data. Regression analysis is just a fancy way to run a trendline.

For a practical example, if we look at the last 17 years of data from Melbourne segmented by the inner, middle, and outer rings, we can see clearly defined periods of over or undervaluation compared to the mean for each sector.

One way we could think about this is the dotted regression lines represent the fair market price, and everything over the mean is a period of relative overvaluation. Conversely, everything under the mean is a period of relative undervaluation.

One observation that is immediately apparent is that prices can remain above or below the mean for years at a time.

The second observation we can make is that Melbourne is in a period of relative undervaluation, and the inner suburbs are relatively more undervalued than the middle and outer rings. Of course, specific projects or properties may buck this trend, but when looking for an investment, this is often a good starting point to narrow down your search.

The valuations we see reflect expected future earnings. The most bearish news usually comes when the market is lowest, and most people expect things to worsen. On the other hand, just when most people are convinced the boom will last forever is when the market has peaked. People are usually willing to pay a little bit more than what they think a property is worth just to secure it when a market is booming because they think it will be worth more in the future.

Despite how obvious it looks in hindsight, times like this, where the market is endlessly negative about the property market, are generally the hardest times to make a purchase decision, even though they represent the best times to buy. In the long run, those who can buck the trend and have the courage to buy when everything seems to be falling apart around them will stand to make the best returns.

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Posted by Gavin Chau, on 6th Dec 2022