by Calculated Risk on 7/16/2009 09:41:00 PM

Earlier today, DataQuick reported that home sales increased in the California Bay Area. The report mentioned "a perception among potential buyers that prices have bottomed out."

First, a little history: When the housing bubble was inflating, the demand for housing surged with the widespread use of non-traditional mortgage products. Looking at a supply-demand diagram, this surge in demand pushed the curve to the right.

At the same time speculators were buying up properties, reducing the supply with the intention of selling later at a higher price. This activity shifted the supply curve to the left (this activity was classic storage).

So with the surge in demand, combined with speculators removing supply from the market, prices skyrocketed.

This is exactly what I described in April 2005: Housing: Speculation is the Key

Of course, once the bubble burst, the supply curve shifted back to the right with speculators unloading properties and all the distressed sales. At the same time, demand declined sharply as speculators disappeared and lenders tightened standards.

If housing was a perfect market, prices would have fallen rapidly to the market clearing price. However housing prices are sticky downward - as I described in 2005 post: "[R]eal estate prices display strong persistence and are sticky downward. Sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices.

This means real estate markets do not clear immediately, and what we usually observe is a drop in transaction volumes."

This doesn't mean prices are stuck - just sticky. Prices have been falling in most areas for three years, and will probably fall further.

And this brings us back to the DataQuick article. Just because demand is picking up a little, doesn't mean prices have bottomed. Note: Ignore the median price in the article - that is rising because of the change in mix.

Assume the following diagram shows the current housing market supply and demand. With the current supply and demand curves, and a perfect market, prices would be at P₀ and quantity Q₀. However prices were actually at P₁.

Note that demand doesn't fall to zero just because the price is above the market clearing price.

Now prices have fallen from P₁ to P₂.

Click on graph for larger image in new window.

This has increased the demand from Q₁ to Q₂.

I've drawn the diagram to show P₂ is still above P₀ (typo fixed). Naturally the current buyers think "prices have bottomed out", but they haven't for the market shown.

There are clues in the DataQuick report that prices are still too high. The volume of sales is still below normal, foreclosure resales are 37.3 percent of the resale market (a very high percentage) - and foreclosure activity "remains near record levels". And the foreclosure resale statistic don't include short sales, and the recent data from Sacramento suggest short sale activity is fairly strong.

There are other reasons to believe prices will fall further, but I just want to point out that the small pickup in demand doesn't suggest a price bottom.