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Of course, the speculative run-up in housing prices, after peaking in 2006,

culminated in unprecedented price declines over the next two years of 30 to 50

percent. Why did so many home buyers, homeowners, lenders, and financial

institutions believe that housing prices could go nowhere but up? Simple psy-

chology accounts for a large part of the answer. Such beliefs are supported by

a strong (often unconscious) bias toward overoptimism. According to surveys

taken over the last 20 years, homeowners report that they expect housing prices

to increase in the future by some 10 percent per year. These predictions have

been very stable—before and during the price run-up and even after housing

prices plunged. Moreover, individuals selectively cling to reasons—more qual-

ified buyers, high demand in growing cities, the scarcity of land and housing

in the most desirable locations—that support these beliefs, while overlooking

or dismissing disconfirming evidence. To sum up, the way to overcome these

psychological biases is to keep firmly in mind the 50-year “big picture” of house

price movements.

Barometric Models

Barometric models search for patterns among different variables over time.

Consider a firm that produces oil drilling equipment. Management naturally

would like to forecast demand for its product. It turns out that the seismic crew

count, an index of the number of teams surveying possible drilling sites, gives

a good indication as to changes in future demand for drilling equipment. For

this reason, we call the seismic crew a leading indicator of the demand for

drilling equipment.

Economists have identified many well-known leading indicators. The num-

ber of building permits lead the number of housing starts. Stock market indices

(such as the Dow Jones Industrial Average) indicate future increases and

decreases in economic activity (expansions or recessions). Such indicators,

however, are not without certain problems.

1. Leading indicators are not always accurate. According to one
   humorous economic saying, declines in the stock market have
   predicted 14 of the last 8 recessions.


2. The amount of time between the change in the leading indicator and
   the change in the forecasted series varies. Leading indicators may say
   a change is coming, but they often cannot say exactly when.


3. The change in the leading indicator rarely gives much information
   about the size of the change in the forecasted series.

Frequently, leading indicators are averaged to form a compositeleading indi-

cator. This helps eliminate some of the randomness and makes the indicator

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