Has Reversion to the Mean Died?

Take a trip back with me to 2006 as it was becoming clear that the real estate market in Phoenix and across much the country was in for trouble. (Timelines may vary for other parts of the country; for better or worse, we tend to lead the way.)

Oft mentioned was the concept of reversion to the mean, that prices eventually settle back to historic  levels. In very basic terms, you can think of this as the equivalent of water finding its natural level. And put yet another way, there's a reason why historic averages tend to be historic; while you can't predict short-term values and movements based on the larger average, long-term trends are easier to identify.

Why do I mention all of this? Take a look at the following chart displaying the average price per square foot in Peoria as provided by the Cromford Report:

Data on the Cromford Report goes back to 2001; ideally, I would have preferred to have the chart go back a little further but it serves its purpose in as much as the early years here conform to the historic average of 3 to 5 percent annual appreciation that we would see in a "normal" market.

It's also easy to see when the market started to become overheated in late 2004 and when it reached its peak followed by the inevitable decline - the reversion to the mean that was being discussed five years ago.

But then ... the market kept falling. And falling. Additional factors came into play - the near-meltdown of the financial system, the ensuing credit crunch, the depth of the recession, lenders selling homes at increasingly lower prices just to get them off the books.

None are problematic to the idea of reversion to the mean since, again, reversion to the mean isn't meant to look at relatively short-term fluctuations, only the long-term pattern.

Looking at the chart there are two distinct possibilities - either the market in Peoria, Glendale and the rest of the Valley has to rebound to come back to the mean, and likely fairly soon as the longer we muddle along the bottom the further from the mean the market ends up - or the entire concept of mean reversion no longer exists.

After reading "The Myth of the Rational Market", which takes you through the history of economic and finance theory - it's startling to find how recent many theories are - the latter isn't entirely impossible, in theory at least. But smarter minds than mine tend to dismiss this possibility.

None of this to say the days of appreciation are just around the corner. No one can predict the future. What I can do is look back at the numbers and say that it looks like the Peoria market went from correction to overcorrection in relatively short order.