First, a quick thanks for all the comments on the housing piece. I combined the three parts into one epic megapost. I also moved our site to a new web server over the weekend which should give us more flexibility and room to grow. You’ll notice a new ShareThis button above, as well as a convenient “printer-friendly” view if that’s your thing.
Market Recap
OK, let’s just cut straight to the elephant in the room. The market has gone up 60% from its lows. Sixty percent.
Everybody right now is asking two questions, the first of which is why?
Aside from things generally looking better than they did in the black abyss of March, there are a few other factors at work, one of which is simple mean reversion. When any market moves too far one direction, it typically starts moving back to a more normal mean. March was pretty far down there, and so naturally, one should expect a snap back to more average levels. But it’s only easy to see this in hindsight.
Another possible explanation and contributing factor is a new round of dollar weakness. Check out this chart of the US Dollar Index, which tracks the value of the dollar against a basket of other currencies. It looks a lot like the inverse of the above chart, doesn’t it?
In a global economy, when the dollar goes down in value it usually means that the price of stuff denominated in dollars goes up. That might sound a little strange, so consider this example. Imagine for a moment that you’re a middle eastern oil producer. Pretty awesome gig, I know. At least for now. Crude oil is priced in U.S. Dollars, and if the value of the U.S. Dollar falls 10% relative to your currency, your solution is to simply ask for 10% more dollars in return to make up for it.
The U.S. stock market is denominated in dollars too, and to a certain extent the same relationship applies. The rally since March has been pretty darn impressive, but it’s been magnified by a dollar that’s collapsing in value relative to other currencies. Why is the dollar falling? Simple. The government has been printing them like mad men to ward off deflation.
Stock and commodity prices usually go down during periods of increased risk, but be warned that a sharply strengthening dollar can magnify that effect as investors around the world buy dollars as a safe haven.
The second question everybody is asking right now is where does it go from here?
I wish I knew.
Where the answers may lie
One of the Big Ideas in the still-young field of Behavioral Economics is the concept of loss aversion. In the traditional world of economic theory, the material that’s been taught in universities around the world for a century, individuals are assumed to be rational. Everybody – even economists – understands that this couldn’t be further than the truth. People are not rational. They are emotional and crazy, and they do crazy, emotional things.
The concept of loss-aversion simply states that people are more strongly motivated to protect what they have than risk acquiring potential gains. In other words, people are generally more fearful than they are greedy. Believe it or not, this simple principle had never been accounted for in any branch of classical economic theory.
It might sound pretty intuitive to you, someone who lives in the Real World. But to economists, who live in the magical land of Econotopia, this was pretty revolutionary stuff. Check out the recent laureates for the Nobel Prize in Economics. A lot of them won for doing work on the new frontier of behavioral economics. Back in the day at UCLA I couldn’t take any classes on this. Nobody was taught any behavioral economics, we all just politely accepted and swept under the rug the disturbing notion that our entire field of study was dependent on the erroneous assumption that individuals were rational.
Apparently, that bothered others a lot less than it bothered me. I had to travel by myself to the outer fringe of Econotopia to find material to help me resolve this problem. It was there I discovered Richard Thaler, along with the groundbreaking duo, Kahneman and Tversky. Back in the 90’s these guys only had a cult following, but today they’re suddenly very fashionable! Thaler has a new book out, Nudge: Improving Decisions About Health, Wealth, and Happiness. Check it out. It’s fun for curious minds of all ages.
Stuff like this really gets me excited – it’s pioneering economic theory for the masses, and Thaler has the rare gift of making it interesting without compromising its theoretical merit. Dan Ariely is another one doing legitimate, accessible work in this developing field. He was a frequent guest on CNBC last fall and his voice was a very fascinating, unique one amidst all the the chaos. I wholeheartedly recommend his book Predictably Irrational to econ wonks and regular folks alike.
To bring the discussion back to the markets and where they might be going, keep in mind that last year loss aversion dominated market psychology. When everybody thinks this way at once it leads to spiraling losses as investors sell risky assets and lower and lower prices.
Today, a different form of loss aversion is showing up. Fund managers and investors are terrified of losing out by not participating in the market rally. You might argue that’s actually greed, not loss aversion. But you’re not thinking like a mutual fund manager. If a fund manager’s mutual fund doesn’t go up or fails to beat the market, he typically loses assets because the cost of switching funds is very low for investors; they simply sell his fund and go buy another fund that did go up. Given how mutual fund managers are compensated, losing assets translates directly into losing revenue.
You can see now why it’s so difficult for mutual funds to sit idle while the market roars upward. I can tell you for a fact that most mutual fund managers are not psychologically equipped to handle this. If the market is going up and their fund isn’t, panic sets in. At some point, they buy out of fear, chasing market performance, hoping it will help them beat their benchmark lest investors leave them if they don’t.
It’s always difficult to determine to what extent things like this can move the market. But psychological factors like this can extend trends for far longer than most people think possible. In fact, that’s the first rule of super trends: they always travel much farther than anybody ever thinks possible.
As I’ve said before, I think this market can keep right on running upwards for these bizarre reasons. I just won’t be a part of it. I see better opportunities that carry less risk elsewhere.
Hopping towards performance
After 25 years of investment management and working much more directly and actively with our investors than most funds, we can speak with a modicum of authority on investor psychology.
Investors, by and large, are a fussy bunch. They want to make money all of the time. And the two things that are most annoying to them are 1) losing money and 2) not making enough money when the market is going up. In essence, they want to always be making more money than the market and never losing it, which is certainly an admirable thing to want. However, what differentiates the successful investors from the poor is the degree to which they can reconcile those wants with reality.
There are no investments, no portfolios that go up all the time. Or at least none that are easily accessible or return more than the risk-free rate. There are no traditional investments that always beat the benchmark over every single window. Every investment goes through periods of underperformance and outperformance relative to its benchmark.
Most investors just hop from lily pad to lily pad in search of higher returns and when there are scary waves in the pond, they react by attempting to jump out altogether. Never mind the fact that the appearance of one series of waves doesn’t necessarily mean that a second series is to follow or that a pond that has been calm for a while means that it’s safe to hang out too far away from shore. They hop and hop, hungrily chasing profits, until the rare moments when suddenly fear of loss trumps everything.
With a market like this, you need to figure out what’s important to you and ask yourself some tough questions.
I feel like I’ve asked more questions than I’ve answered in these newsletters. I don’t feel bad about it, though. I firmly believe that the true path to investing success starts with a deep understanding of oneself, and that’s only possible through self-inquiry and self-examination. So few investors understand themselves well enough to make investment choices that are right for them.
Consider:
- Can you sit on the sidelines while the market goes up and up?
- Ignoring the past completely, how big a loss are you willing to tolerate today? Do you think the gains from this point are worth the risk?
- Are you able to make peace with the fact that you haven’t participated in the rally since March? If you have participated, are you able to prevent that excitement from affecting your present and future decisions?
- Will you be happier just knowing that you are in the market regardless of its direction from here?
- What do you believe the future will look like?
These are hard questions. Trust me, it’s a lot easier to simply accept and follow the recommendations of others. The problem with that is that these recommendations may be totally wrong for you and lead to irrational, reactionary decision making at some point down the road. You’re also just following the crowd and could wind up on a lily pad with a few too many other frogs. That’s seldom good for the lily pad or the frogs on it.
Me & You
Today, I might think that TIPS are the bees knees, but if you’re a person who derives satisfaction from movement and activity, TIPS and their boring, mild return stream are going to drive you bananas. I might think that global growth in coming decades will be driven by China and recommend things like copper producers or oil refiners for the long haul, but if you just don’t buy into China’s ascendance, then don’t own things that are predicated on that transpiring. I might think that stocks are generally risky and expensive at this point, valuations which are not justified by what I think will be a disappointing stream of future cash flows. But if you simply can’t sit still while others are partying on as the market goes up, for heaven’s sake, why haven’t you accepted the risks and loaded up on stocks!?!
Look, I ask a lot of questions because I don’t have all the answers. I have managed to accumulate a few answers here and there, but they’re my answers. Some of them will solve your problems, but some of them will just create more.
Unfortunately, you need to be the arbiter of what works for you and what doesn’t. This is an existential reality that you must come to terms with as an investor, and it’s tiring work. Sorry. That’s life. If you want the easy answers, just go follow Jim Cramer, but don’t come crying back here when his picks don’t pan out.
Our goal is to make this newsletter one that is both interesting and useful. Being interesting is a vague, ethereal art. It’s much easier to be useful and we do it by trying to help you be a better fisherman rather than simply catching fish for you.
I like to eat fish as much (actually, more) than the next guy, but as a novice fly fisherman I’ve found much more value in the lessons that taught me how. Lord knows there are plenty of voices out there that tell you exactly which flies to use and which holes to fish. Your mileage may have varied, but my honest experience with those voices has been pretty mixed. The best – by far – were the ones that taught me how to be a better fly fisherman, the voices that simply helped me enjoy the art of fly fishing more.
And would you believe that was what helped me catch more fish?
An industry pauses to reflect
Last week was the one year anniversary of Lehman’s collapse and the spectacularly massive bailout of insurance-firm-turned-casino, AIG. This month the industry has been uncharacteristically introspective, which for a highly introspective fellow like myself, feels very much like home. If only the industry felt this way all the time.
There were a lot of theories about why Lehman went down and why the government didn’t (couldn’t) do more to save it. Lehman’s failure was a seminal event in the history of finance, and it was frequently pointed to as one of the reasons why the markets went into freefall.
One thing that needs to be understood is that Lehman wasn’t the cause, it was a symptom. The disease was fear and a lack of credit-worthiness and that manifested itself in Lehman’s case as a good old fashioned run on the bank. All of a sudden, nobody wanted to lend money to anybody because they were terrified of not getting paid back. The world of modern finance simply doesn’t function when nobody wants to lend money.
Consider this delicious exchange from 1992’s way-ahead-of-its-time hacker classic, Sneakers1. Robert Redford plays the security consultant hero, Martin Bishop, and Ben Kingsley plays the villainous technology titan, Cosmo.
Cosmo: Posit – people think a bank might be financially shaky.
Martin Bishop: Consequence – people start to withdraw their money.
Cosmo: Result – pretty soon it is financially shaky.
Martin Bishop: Conclusion – you can make banks fail.
Cosmo: Bzzt. I’ve already done that. Maybe you’ve heard about a few? Think bigger.
Martin Bishop: Stock market?
Cosmo: Yes.
Martin Bishop: Currency market?
Cosmo: Yes.
Martin Bishop: Commodities market?
Cosmo: Yes.
Martin Bishop: Small countries?
…
Cosmo: There’s a war out there, old friend. A world war. And it’s not about who’s got the most bullets. It’s about who controls the information. What we see and hear, how we work, what we think… it’s all about the information!
This was what killed Lehman Brothers. It was what killed Bear Stearns. It wasn’t a war, per se, but it did ultimately wind up being all about information and perception.
Yes, these firms had legitimate problems. But during periods overrun with fear and panic, information flow gets a little fuzzy. These firms were technically fine until concerns developed about their solvency and their ability to pay back their creditors. Naturally that sparked a run in their prime brokerages – every hedge fund I knew at the time was pulling their accounts with Lehman as quickly as they could. With a diminished capital base, these banks now actually were insolvent.
Now: given that the problem was information flow and image, what would make for a logical solution?
Make them look better.
I think at the time, we all had a sense that, as bad as things seemed, things weren’t really as bad as they seemed. The government’s natural response was to get George Bush and Hank Paulson up there to simply tell us that everything was going to be fine. That didn’t work for a variety of reasons from an exhaustion of credibility to a lack of understanding of the problem. But soon the banks and the government did figure it out.
Step one was the stress-tests. These were ridiculed at the time, by myself, other hedge fund managers, and other economists and academics. The tests were kind of ridiculous, with odd, arbitrary assumptions and subject to big-time self-reporting bias. It turned out that none of that mattered. The market bought into the conclusion that these banks would be fine. Suddenly these were solvent, sound financial institutions again.
The FDIC guaranteed all deposits up to $250,000 – never mind the practical impossibilities of that. It was the perception of a sovereign safety net that truly calmed people down. It didn’t matter that the net wouldn’t support everyone if they fell. For the third time in a century, economists dusted off their Keynes and saw that, yes, it was indeed theoretically possible for the government to step in and guide us all through.
Look around. Epic stimulus programs. Are these really a good idea? Economically, maybe not. But if they make people feel better about things, then they probably are. Look at banks paying back TARP. Financially, this is a terrible idea. They got that money at great terms with little questions asked – why give it back? What matters was the message these banks would send by paying back TARP, that they were strong enough not to need it. To restore confidence. Not every bank has indicated a desire to pay back TARP, but those that haven’t, like Bank of America, have boasted about their success at raising capital.
As I reflect this month on the events of the last year, this is what sticks with me. Our fears were significant, but I think we’ve all learned that we have a government that’s big enough to mitigate them if it wants to. The perception of a sovereign safety net will have major consequences, both intended and unintended. And with that net in place, I think it’s naive to assume that it won’t be tested again and again.
Whether or not it actually holds up is anybody’s guess.
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1Seriously, this should go down in history as one of the best casting ensembles of all time, or certainly for anything not directed by Robert Altman: Redford and Kingsley, Dan Aykroyd at his best, Sidney Poitier, Mary McDonnell, the criminally underappreciated David Strathairn, River Phoenix in one of his last performances, an early Donal Logue, Timothy Busfield, character-actor wizard Stephen Tobolowsky, and a even James Earl Jones in a scene-stealing bit part.
Today we’ll embark on a little journey through the current housing market. There’s been a lot of hubbub in this sector lately and at long last (phew!) some legitimately good news seems to be emerging. As usual, the story is both more complicated and simplistic than it seems at first blush. In this piece we’ll cut through a lot of the noise and bring into focus a few things that really matter.
Is the crash is over?
The term “crash” in the housing market takes on a slightly different meaning. Suddenness is the key dynamic in crashes of any sort, and in real estate nothing happens suddenly. The housing market has been “crashing” for two years now.
Recently we’ve had slight increases in existing sales, a slight increase in the Case/Shiller Home Price Index, and a slight increase in median sale prices. Prices and home sales typically rise during the summer months so a lot of this is seasonal and a lot has to do with a decline in distressed sales. Let’s everybody hold their horses until we move through winter.
But the good news is that the crash is probably over, not because of these flimsy data points, but because valuations are finally entering a range that makes some sort of sense. I’m certainly not saying that real estate can’t go lower from here (in fact, in a minute I’ll show you that it can), just that there is finally some light in the tunnel in the form of price stabilization and I don’t think that the next 12 months will look like the last 24. Those of you buying a house today are not going to get burned the way people who bought houses in 2005 and 2006 did.
The bad news is that there isn’t going to be a recovery in the sense you might be expecting. Those of you buying a house today are not going to be rewarded the way people who bought houses in 2000 and 2001 were.
Have a look at this:
Well, does it? Does that chart make you excited?
That’s a 20-year chart of real housing prices before the bubble.
Guess what. Now that the finance-bubble has popped and real estate has fallen to more-sane-but-not-cheap valuations, it’s a good bet that the next 20 years of housing prices will look very similar. Yawn.
I don’t mean to sound flippant, I’m simply trying to illustrate that the days of our obsession with home prices are quickly coming to an end. Ten years from now nobody is going to be nearly as concerned as they once were with whether their house went up or down in value over the previous 12 months. This will be the indirect result of the stabilization.
During the dot-com fallout we needed something to cling to, an “investment life raft” that was reliable and easy to understand, something that would soothe our psychological anxiety as the stock market was crumbling around us. The result was a wave of personal finance literature about how one’s home was actually one’s biggest and most important investment. The artificially-low interest rate environment simply added fuel to the fire, as did cherry-picked data that gave people the impression that home prices never went down. Those nasty little seeds would later give birth to perhaps the greatest bubble in history.
Your home is not an investment in the typical sense. It’s a mechanism for forced savings and always has been for most of the entire history of real estate prior to the early 00’s.
During the bubble we forgot all about that and it empowered us to do ridiculous things. Maybe we traded up and transferred all that savings to a bigger house with a bigger mortgage. Maybe we tapped some of that savings with a HELOC and used that money on… a new boat. It was an investment that always went up!
But prices started going down and wiped out all the rest of the savings we’d accumulated whether by 30 years of steady payments or the rapid increase in price during the bubble. I realize that has been rehashed elsewhere ad nauseum, but it brings me to my next point which hasn’t quite been getting the attention it deserves.
Negative equity is a serious, serious problem right now
Just because the crash is over doesn’t mean real estate’s woes are in the rear view mirror. Far from it. In fact, we’re now just getting to the really tricky part.
It’s estimated that right now around 15 million homes are worth less than the mortgages on the properties. That’s about a third of all mortgaged homes. Yikes! Here in Nevada, about 66% of homes are estimated to be in a negative equity situation. Sure, much of that is Las Vegas’ problem, but up here in Reno it’s still a legitimate issue. Deutsche Bank recently estimated that the number of homeowners with negative equity could approach almost 50% by 2011. Double yikes!
This is a massive, massive problem for the banks and entities that hold the other side of these mortgages. Who knows how they’re accounting for them on their balance sheets. Who knows what that’ll do to their earnings, the financial system, and the market/economy at large if and when they start writing more of that stuff down. Banks are very clever. All that bad debt isn’t any better today. Some of it may have changed hands, but it hasn’t gone away. Bad debt doesn’t just disappear; somebody pays.
On the individual level, negative equity is a big problem because it makes people feel poor. Not enough people in this industry gave the wealth effect our nation felt during the housing boom enough credit for the way it drove consumer spending and thereby fueled GDP.
This was a favorite chart of mine from a few years back:
Not exactly a shining endorsement of the U.S. economy in the early 21st century. Things have been much worse over the last decade than we may have realized. Public policy and the financial environment has basically amounted to “giving the kid more candy to keep him from getting cranky.” Parents know that usually ends with tears all around. But this is how we like to solve problems in the U.S. We are a nation hypersensitive to short-term pain and democracy gives us the power to vote ourselves what we wish whether it’s in our long-term interests or not.
To the matter at hand: it’s not too simplistic to say that nearly all the economic growth we enjoyed post-2001 was due to home equity credit extraction. All this is very consistent with Friedman’s permanent income hypothesis which I’ll break down for you as follows:
- We expected our homes to keep rising in value.
- We felt more wealthy.
- We spent more as a result.
Now, reverse that within the framework of a falling or even flattening real estate market, and it adds up to a consumer that’s much less comfortable spending money.
As the son of an arch-conservative, fiscally-hawkish commodities trader I suppose it was impossible for me to ever grow up into a man that wasn’t compulsively obsessed with the concept of value. I would never have called myself a big spender to begin with, but after the last year, even I am noticeably more careful with how I spend my money. I’d wager that – regardless of your situation and where you’ve come from – today you probably feel the same way.
Tell me that’s not a huge drag on economic growth.
How do we solve the problem?
If you think about it logically there are really only two solutions to the negative-equity problem.
- OPTION A: Housing prices re-inflate substantially (think 50-100%), which is flat out ridiculous.
- OPTION B: The value of these mortgages need to be marked down and the lien holders i.e the banks eat the loss. It’s equally ridiculous to do this all at once given the chaos of last fall.
There have been a variety of proposals in between those scenarios that have been suggested, and the path that we seem to be travelling seems to be closer to Option B since that’s the only one that is at least somewhat realistic and the only one that anybody has any sort of control over.
During the crisis of 2008, the decline in value of housing relative to the debt against it and the myriad derivative contracts stemming from this problem made many, many financial firms technically insolvent. That was when Captain America flew to the rescue and controversially used public funds to recapitalize (“bail out” if you prefer) these insolvent firms. Step two was to create an environment where banks could be extremely profitable and then use those profits to slowly offset the losses associated with all this stinky debt. When these banks started making tons of money in Q1 and Q2 this year, this too was controversial.
Eventually, all that debt will be worked off and replaced with better debt. That’s how banks handled the last debt crisis, and it’s how they’ll handle this one. But it’s like dieting. Losing weight takes time and dedication, and it isn’t much fun. I recognize that we are a nation obsessed with quick fixes, but it’s impossible to clean this mess up overnight.
We all may stop caring so much about home prices, but the state of this market will have major economic implications for a long time. Hence, the “New Normal” that I’ve been discussing here for months now, and that’s also been discussed (in far more elegant, effective language) elsewhere. Life is no longer easy for investors.
A nose for real estate
I have a 3 year old Westie named Bishop. As a fellow schedule-oriented creature, he looks forward very much to our afternoon walks every day from 3-4pm after I get home from work. Our neighborhood is typical tract housing. It’s a nice neighborhood in one of the nicer parts of town, but it’s modern tract housing nonetheless.
During the first year of our walks around the neighborhood it seemed like just about every house was for sale – no joke, 5 or 6 for sale on a street of a dozen homes. This, of course, was 2006, right near the peak. Something wasn’t right and I’d guess that at that point even my new puppy had a better idea of where real estate was headed than a lot of the crazies that were trying to flip this and that.
By mid-2007, the “For Sale” signs slowly started to disappear, but that’s when the real problems were beginning. Stocks (always a leading indicator) started going down and margin desks around the world started calling in leverage. Construction on the new development to our east stopped immediately. Bishop didn’t mind, never really a fan of the noisy dump trucks and bulldozers. But no more dump trucks would mean no more people getting paid to drive them. What consequences would this have? Neither of us were exactly sure.
By mid-2008, the neighborhood was dotted with one or two dead lawns per cul-de-sac. Weeds had overtaken other properties. Most of these houses were built between 2003 and 2006 and by 2008 had been nearly halved in value. I bet Bishop a bag of Pup-Peroni that well over half of all the mortgaged houses here were under water. He just cocked his head and looked at me funny.
Today when we walk around the neighborhood, things feel a little better. There is what seems like a normal number of houses for sale. But there are still empties here and there, and still a few weed-infested, dead lawns. Some of you may have had experiences like this, but it’s likely that this is still a regional phenomenon. Until these vacant or distressed houses sell – not all of which are technically listed for sale, mind you – the housing market will not have found its bottom. There’s still simply too much supply on the market and counting on an increase in demand to clear this condition is a shaky proposition. I doubt even Bishop would take that bet.
The point, though, is that these houses aren’t appreciating in value. They were built in the middle of the boom and bought with little money down. Virtually every house that sells in my neighborhood today does so at a price less than the mortgage associated with it. Somebody eats that loss, and no accounting legerdemain can make that write-off disappear from a bank’s financial statements. Unless, of course, the bank in question is Goldman Sachs.
How much house can I afford?
Now, a simple exercise to illustrate the concept at the heart of some new analysis.
STEP 1: What is your total annual household income?
STEP 2: If you had to buy a new house tomorrow, how much house would or could you buy? A $250,000 house? A $1.0 million house?
STEP 3: Divide that price by your annual income.
This is your price/income ratio. It’s probably somewhere around 3:1, right?
This exercise obviously won’t apply if you’re retired or are in a similar situation where you now have a lot of assets but not necessarily a lot of income. It also breaks down at the high end of the curve; if you’re in the market for a $5 million home, you probably aren’t earning $1.7 million per year. Maybe you are. I don’t know. If so, you clearly don’t need to listen to little old me! So just imagine that you’re somewhere in the middle of your career – just enough liquid cash for a 20% down payment and enough income to cover the mortgage and the rest of the monthly bills.
The neat thing about this calculation is that we can do it for the nation at large. At the end of the second quarter 2009, the median annual household income in the U.S. was $60,671 and the median existing home sale price was $181,711. This was a ratio of almost exactly 3:1. In aggregate and on average, people in the United States were buying homes that cost around three times their annual household income.
Over the long run, this is a ratio that stays somewhat constant. There’s good reason for it, too. Lenders typically won’t lend to you if they know you don’t have enough income to meet your monthly mortgage payments and homebuyers will typically buy as much house as they can afford. These two forces make for a rather natural equilibrium.
Most of the chatter one hears in the housing market centers on home prices, prices, prices, whether it’s existing home sale prices or the Case/Shiller price index. Every so often we hear about mortgage rates or the number of homes sold. But one thing that’s seldom discussed when it comes to housing is incomes. The level of one’s income – both current and expected – is a very important factor when it comes how much an individual will spend on a house. It’s probably the most important thing, so long we live in a world where banks require down payments and don’t lend money for free.
This is one of my favorite charts that I maintain one I wish I had in front of me back in 2005:
The recent jump in both price and price/income ratio is purely seasonal. We saw it last summer, the summer before, and we’ve seen it in pretty much every summer before that. The only reason that doesn’t appear on on this graph is because that data set is published annually before 2007 and so I had to smooth it to a monthly trend. (If anybody knows any good data sets for housing prices, please let me know!)
Looking at this chart makes a few things very clear:
First, home prices at the peak were flat-out insane and though we may all have felt that things were kind of expensive at that time, we really, really had no idea just how ridiculously overvalued residential real estate was by every metric imaginable.
Second, home prices right now in real terms still might be considered moderately overvalued. In other words, the blue line has room to go down. Over the long run the chief driver of home prices is inflation, so when you factor inflation out, prices are fairly stable. They only really go up when aggregate wealth and incomes are increasing in real terms, or the environment is changing in a way that makes it easier to pay more money for a house. Things like the popularization of the 30-yr mortgage, the tax incentives of mortgage interest, and the expansion of lending to those who previously had no access to credit i.e. subprime lending. All these environmental changes allowed people to pay more money in real terms for a house.
Taking away those things would add downward pressure to home prices. Can you imagine what requiring people to pay cash for a home would do to prices? What if Congress changed the tax code so that nobody could deduct mortgage interest on their tax returns? The last decade was an eventful one. Very quickly it became very easy to pay a lot of money for a house and then even more quickly, all those things that made it so easy to pay a lot of money for a house were taken away.
The price/income ratio is much more reasonable today than it once was, though it’s still about 5-10% above the long-term (ex-bubble) average and nowhere near historic lows or the lows we saw in the 1991 recession. Factor out the steroidal effects of the credit bubble and homes are still more expensive relative to incomes than they have been in 25 years. Kind of a scary thought, no?
You’ll notice a jump in the price/income ratio in the early 80’s, but that wasn’t because real house prices went up (they actually went down!) but because incomes fell by so much during that nasty recession.
Incomes haven’t fallen so much during this recession but it’s interesting to note that they have been flat-lining for the last decade. I know you didn’t need another reason to convince you that everything since the dot-com bubble has been financially-engineered smoke and mirrors, but there it is.
Given the massive hurdles our economy now faces and a historic scaling-down of the labor market that will likely continue for a while, do you really think incomes are primed to rise?
With banks failing all around and others curbing their lending dramatically to reduce risk, does anybody out there think that credit will magically become easier to obtain? Think the 2%-teaser 0%-down mortgage will make a comeback?
Because of the collapse in the stock market and real estate market, American household balance sheets aren’t looking too great. Households are still overleveraged, too heavy on the liability side and stuck with assets that are worth a whole lot less. Net worth is way down which means less money for a down payment which means less people buying houses which means lower prices. That doesn’t even begin to address the psychological effects that reduced net worth also brings.
I have a very hard time believing that home prices will “recover” here, much less even begin to trend back upward.
Should I buy a house?
Sorry folks, but there still could be another 10-15% downside in home prices.
I know. That sounds crazy. Another 10-15%? It’s clearly possible from a technical analysis perspective.
When you realize the bubble in that chart (which was deceptively slow to form) was completely bogus and based on easy finance and lax lending standards, and add on top of that all the current fundamental problems with real estate right now like massive excess supply, and add on top of that the economic headwinds our nation will be up against over the next decade, another 10-15% drop starts to sound more reasonable.
A drop like that isn’t quite so scary on its own, but given the complete lack of upside in housing it should give you nightmares as an investor. I try and read as much material as I can from as many different viewpoints, but I’ve yet to come across any reasonable arguments for significant appreciation in home prices. Call me a Negative Nancy, but I think stabilizing prices are a best case scenario for this market.
That being said, if:
- You need a place to live.
- Plan on living there for a long time.
- Have good credit and can easily afford the monthly mortgage payments.
you have my blessing to venture forth and buy a house.
The Homebuyer Tax Credit
Speaking of buying a house, check this out:
NAR estimates that about 1.8 to 2.0 million first-time buyers will take advantage of the $8,000 tax credit this year, with approximately 350,000 additional sales that would not have taken place without the credit.
OK, current and future taxpayers, that’s about $16 billion you just spent to spur home sales. That’s roughly $45,700 per additional house sold. Hope it was worth it!
Before the bubble, back in the 90’s, existing home sales would run around 4 million per year. As the bubble was inflating, sales would run about 5 million per year. During the peak, existing home sales topped out at over 7 million per year! In 2009, sales have averaged at about a 4.7 million annual rate.
Incentive programs like the homebuyer credit typically have the effect of pilfering future demand and transferring it to the present. That’s not always a bad thing. But people don’t buy houses the way they buy milk. Inventory turnover in the housing market is very, very low relative to other goods. Does this mean that home sales in 2010 will clock in 350,000 units below 2009, so long as everything else stays constant? Not quite, but within that 350,000 additional homes that were sold is a certain number of people who were on the fence and looking to buy a house at some point in the future. Those folks did it this year and won’t next.
I mentioned above that environmental changes that enable individuals to spend more money on a house can positively impact prices. It’s difficult to measure, but the Homebuyer Tax Credit has unquestionably had a positive effect on prices. How could it not? With the current median existing home sale price where it is, that credit amounts to a 4-5% discount! Keep in mind, however, that this is not a permanent shift in the environment. Any positive effect this has had on prices will be short lived.
More broadly speaking, it’s disturbing that individuals seem so reluctant to spend unless they’re given a freebie in the form of a government incentive like this homebuyer credit or cash-for-clunkers, or a midnight sale. That’s very deflationary when it comes to prices, and I wouldn’t bet on retailers regaining significant pricing power any time soon. Assume for the sake of argument that the U.S. consumer is in dramatically better shape to begin calendar year 2011. Will he have forgotten the trauma of ’07-09? Will he be willing to pay full price for the goods he so recently was purchasing at significant discounts? Tough to say for sure.
At least it’s stimulating…sort of
Any way you slice it, that’s still about $16 billion of stimulus. $16 billion is a lot of money, but it doesn’t really move the needle of a $14 trillion economy. Families will get that $8,000 back after filing this year’s taxes and then what will they do with it? The last time Captain America handed out free money, in early 2008, people wound up saving most of it or paying down debt. Maybe this time they’ll spend it.
Either way, the effect is temporary. Policies like this don’t make the economy any stronger over the long run, they won’t create new jobs, they won’t keep putting money in people’s pockets, and they won’t keep home prices from going to where they ultimately need to go.
Whether the stimulus was the right thing or wrong thing to do is best left for another debate in another forum. My generation has the rest of our lives to figure this out and come to a conclusion whether all the costs were worth it. None of that is going to get answered today.
To bring the discussion back to housing and summarize: the credit is unquestionably positive for prices over the short run and unquestionably negative for prices beyond that, but in the grand scheme of things it probably won’t matter all that much.
It’s like eating a Snickers bar. It tastes great and gives you energy for the next hour or so but then comes the crash and the extra fat your body now has to deal with. Tomorrow we will have forgotten about everything aside from what it cost us.
The Pig in the Python
I hate snakes, but this story creeps me out even more:
Certainly you’ve seen or heard of houses in your neighborhood that are sitting empty, where the previous owner, unable to make the monthly payments or unwilling to deal with all the negative equity, had simply walked out and left the keys on the kitchen counter. You might also have heard stories about people who have stopped making their monthly payments yet continue to live in the house. From what I gather anecdotally and economically, this is frighteningly common.
A couple months ago a colleague of mine was at a local event and he ran into a guy who was in a negative equity situation (this is Reno, after all), and he hadn’t made any mortgage payments in well over a year. Instead of completely walking away, he moved in with his parents and – get this – started renting out his other house! Not only was he not paying his mortgage, he was collecting pure income on the property!
Yes, that’s disturbing behavior, and probably illegal. But what’s almost equally disturbing is that the bank had done nothing about it. Things are really hazy in the world of banking right now, but how bad must things be where a mortgage can go 540 days past due and the bank not bother to take any action whatsoever to evict the resident or at the very least, make sure they aren’t renting it out on the bank’s dime!
I think it could have something to do with capitalization. When a bank forecloses on a house, it’s forced to mark that house to market, a value that is almost certainly lower than the existing value on its books. Write-downs like that en masse are disastrous for bank balance sheets, and with these entities on such shaky footing with such a delicate capitalization, I suppose it shouldn’t surprise me that they have been dragging their feet to resolve these problems. The last thing on earth these banks need is more widespread fear that they’re insolvent. That was a root cause of the mess a year ago.
Right now, this is the proverbial “pig in the python”. There’s a whole lot of fat and toxic waste on these bank balance sheets – some more than others – and it’s just going to take some time for that all to get digested and pass on through. It won’t happen overnight. Some of it will be nutritious, but, to extend the metaphor, this was a pig that was mostly poison.
More Pigs in the Python
And now for my next scary story, which some of you may have heard before. Below is a chart that was popular in certain concerned circles a year ago. It’s fairly self-explanatory.
That’s some heavy-duty rate-resetting taking place next year and the year after that.
Subprime is behind us. These were the loans put on during the bubble with ridiculously accessible terms for the first 1 or 2 years that would then convert to more conventional mortgages, the terms of which, would never in a hundred years make sense for those borrowing the money. Not that the bank that wrote the loan cared, as it had already been packaged and sold downriver, somebody else’s problem. But we’ve all heard enough of that.
From the chart, you can see that the next pigs in the python are Alt-A and Option ARMs. These are borrowers that aren’t technically subprime, but certainly aren’t quite prime, either. The economy has…changed a little bit since these loans were put on the books in the middle of the decade. Today’s Alt-A borrower might look a little more like yesterday’s subprime borrower than a lot of banks may want to admit.
Option ARMs are the “Pick a Pay” loans you may have heard of where the borrower can choose interest only, interest + principal, or a minimum payment like your credit card. They are primarily good credit score borrowers but the loans are mostly no-doc loans. A majority have negative amortization schedules or high loan-to-values. These are messy products.
There hasn’t been a lot of talk about rate resets this year because you can see that in 2009, relatively little is happening on this front. That will change next year and 2011. “Alt-A” and “Option ARM” aren’t quite buzzwords yet, but by this time next year they’ll be a part of everyone’s vernacular, though not to the extent that “subprime” was. There’s no question “subprime” has a subtly-malicious je ne sais quoi that “Alt-A” lacks.
Realtors: Not Optimistic
According to an eye-opening survey of real estate agents on home purchases and mortgage activity in the second quarter, short sales that require bank approval are taking an average of about 10 weeks right now.
There are countless other interesting tidbits in the 165-page report, but let me do the work for you and highlight the interesting ones. My comments are in brackets:
- “Down payment for mortgage” is the #1 impediment to first-time homebuyers seeking to buy a home. [This is not good for long-term housing strength.]
- The market for home purchases can be divided into segments of 26% for damaged REO, 23% for move-in read REO, 14% for short sales, and 36% for non-distressed properties. [Whoah. Nellie. 2/3s of all sales in 2Q09 classified as distressed!? Is this real demand for housing or just another facet of the public simply demonstrating an unwillingness to consumer unless they’re getting a “deal.”]
- 43% of homebuyers are first-time homebuyers. [From the homebuyer credit. As discussed, this is a temporary increase in demand.
Qualitative conclusions (with statistical support):
- Non-distressed property sells slowly at small discounts, most often to first time homebuyers and current homeowners; few investors buy non-distressed property.
- Short sales, while significantly discounted, sell slowly, most often to first-time homebuyers.
- Few current homeowners list their property for sale and/or buy another property except for relocation or under duress. [Somewhat disturbing that people are only buying/selling when they are forced to. Bad news for the aspirational upper end of the market.]
- The upper end of the housing market consists mostly of non-distressed properties that are initially listed at premium prices, but must be discounted to sell after lingering on the market. [Sound familiar?]
- Issues related to increasing mortgage rates are expected to grow in importance.
- Real estate agents view homebuyer tax credits as important in increasing home sale transactions and stabilizing prices, but in general, they favor time-based solutions to stabilize the housing market over financial incentives.
The results of this survey jive really well with what we’ve been talking about for the last few weeks. This is good data, too. Campbell Communications is in the business of conducting surveys, and there’s reason to take this information seriously. It’s reliable information straight from folks on the ground level.
And speaking of realtors…
The National Association of Realtors says you should buy a house
Not that you need more reasons to be skeptical, but does anybody remember these ads?
That’s from over a year ago. Home prices have fallen about 15% since then. Hope you didn’t buy a house on their recommendation! But seriously, who’s taking advice on housing from the National Association of Realtors? If you are, you deserve what you get.
Go ahead and call me a conspiracy theorist, but of course the NAR has a bias. Their core purpose is “to help its members become more profitable and successful,” which, given the existing compensation structure in Realtor-ville, can only be achieved through more home sales or home sales at higher prices. Could you imagine somebody like uber-bear Nouriel Roubini as the head of the NAR? I can’t picture it either.
The NAR’s Grand Poobah, chief economist Lawrence Yun, said a few weeks ago:
The housing market has decisively turned for the better.
There you have it. It’s turned for the better!
Now, this is a guy who not only denied there would be a recession in 2008 as many economists were revising their forecasts downward, but adamantly asserted that home sales and prices would remain strong through the year. Once the recession was officially declared and backdated to mid-2007, Yun said it would end rather quickly with unemployment peaking at 6.7% before steadily heading down and that home prices would – you guessed it – remain resilient throughout. Goodness gracious! It sounds like all the realtors around the country underneath him have a much more realistic view of today’s market.
I don’t mean to pick on Dr. Yun. It’s a cheap shot and hindsight makes that easy. As a fund manager, I know what it feels like being on the other end of that kind of criticism. A block of our lives is unavoidably public. We do the best we can with what we have, and a lot of times we’re just plain wrong. On balance, all the old hands in this business have really thick skin and are adept at learning from their mistakes. Those that don’t fall by the wayside and find jobs elsewhere.
Yun may have a very clear bias, and he may have been way wrong about a whole lot of stuff, but he is right about one thing: housing is key to sustainable economic growth.
It sounds trite, but rising home prices right now would solve a lot of our current economic problems. I point this out because endemic in that solution is a problem that’s very deflationary. This is why I think that all those that are super-freaked out about inflation are not only not living in the present, but too far out in the future.
Watch the health of this market. It will require diligence and effort to stay focused on this, because let’s face it, the future of the housing market is pretty boring. There is no money to be made (for the average person) in housing now or at any time in the next decade. But there is money to be made by the individual who stays tuned in to this market, and understands the effects it has on other markets and the global economy.
The stock market has rallied something fierce this summer, but that rally hasn’t been confirmed by the housing market. I know the stock market doesn’t revolve around housing, but 70% of the economy is consumer-driven, and consumer psychology has a lot to do with the health of the housing market. If I’m making strategic long-term investment decisions in the stock market, I’d like to see some legitimate strength in housing, though at this point I’d probably settle for a clear, definitive bottom.
A crucial disharmony
As something of a behavioral economist with a foot and maybe an arm in the Austrian camp, I’m very interested in monitoring the psyche of the consumers in this market. Right now, psychology in the housing market has suffered catastrophic damage after a near-fatal accident. How long until that’s been repaired? How long until the anchor of negative equity lifts and how long after that do we stop worrying it may happen again? How long until our homes make us feel wealthy instead of poor? This stuff is obviously very difficult to measure, but it’s of paramount importance to this market, and in turn, the global economy as a whole
When I talk to people about housing and ask them what they think about the future, I often hear things like “eventually prices will go up again,” or “now that it’s gone down so much it probably won’t go much lower.”
In a rational context these statements are, quite simply, false.
As we pointed out above, prices don’t have to go up again any time soon. And the fact that they have fallen so far has very little to do with whether they’ll keep falling. Home prices are dependent on a lot of factors, but most importantly,
- How much current and future income individuals have available to allocate to a house.
- How accommodative the environment is to enabling them to pay more money for a house.
What makes all this really interesting is that when I talk to people about the broader economy right now, I do not hear the same optimism regarding incomes and the credit environment. Right now, most people seem to feel that the labor market is going to be a sticky slog for a long time and nobody seems to think aggregate incomes and wealth will increase the way they have in the last two decades. And who do you know that’s optimistic about the credit environment? Have you spoken with anyone who thinks that lower interest rates, lower down payment requirements, and lower credit standards are in our future?
The tiny psychologist on my shoulder wonders how people reconcile these two views. The one is so clearly dependent upon the other.
Perhaps I’m missing something. Markets of any type are heavily influenced by psychology, and efforts to understand this dissonance could be quite profitable. I wish I had the answers.
I see now I could go on and on. I haven’t even touched on rising foreclosures. More and more delinquencies from all types of borrowers (not just subprime). Historically high inventories and high months’ supply. Historically low lumber prices. The unknown ramifications of “Shadow Housing Market”.
Right before this letter went to publish, I discovered this from Whitney Tilson’s T2 partners; he went on for 155 pages so I don’t feel too bad about rambling. Tilson’s a pretty smart guy and a rational voice. He was on top the financial meltdown pretty much from the get-go. The report is worth your attention but the faint of heart should probably stay away.
I realize now I could have saved myself a bunch of time over the last three weeks and just linked to this report! Tilson does an embarrassingly better job with the material than I.
And now for something completely different
I promised you some good news, so we’ll close on a happy note.
Believe it or not, despite all my cynicism and skepticism, all of this mess actually gives me quite a bit of hope. Our national spirit has not been defeated.
Americans are remarkable creatures. Is there a more resilient, relentlessly optimistic body of people on earth? The United States is the greatest success story in the last 2000 years and it shouldn’t surprise you that given the track record of our country, our people should be so universally bullish about our long-term future. Despite our numerous failures and mistakes, we have emerged from each stronger, better.
Even during last fall as the world seemed to be crumbling around us (at least for those of us deep inside the financial industry), when I would talk about the crisis to people on both Main Street and Wall Street, the overwhelming consensus sentiment was: this is painful and scary, but we’ll get through it. It was almost eerie, listening to this mantra chanted over and over again, soothing our collective anxieties and reassuring our faith in one another. Really, we were all just in shock.
Today, in housing, activity has undeniably picked up. Yes, it’s primarily distressed sales at the lower end. Yes, it’s been driven in large part by incentives. Yes, the jumbo and luxury markets are still a mess.
But you know what? It’s better than a kick in the pants.
A bunch of new, performing loans are being written every day at terms that actually make sense for bank and borrower, straightforward loans with a much better equity cushion that improve banks’ prospects for long-term profitability and recapitalization.
As I mentioned earlier, the housing market is still stuck in this pre-Copernican mindset where it thinks that home prices are the center of the economic universe. They aren’t. The quality of the jump in sales activity may be poor, and this type of activity may not translate into stronger prices further down the road, but the quantity is good and the tangential effects of this increased activity are a positive thing for the economy at large.
So stop thinking about housing in terms of prices. Adopt a holistic view. I certainly hope I’m wrong about prices; I hope they stabilize soon and start trending upward. But there’s more value to be realized by thinking about what weak prices mean in a broader sense.
I think it means things like lower consumer spending and sluggish economic growth. It means less jobs for a long time in a lot of housing-related sectors, especially construction. It means opportunities will be highly bifurcated – there will be lots of good stocks to buy and lots to steer clear from. In late 2007, I adopted a blanket strategy of categorically avoiding financial stocks and anything too connected to the banks. With all the uncertainty and toxicity still floating around out there, I think that’s still a prudent thing to do.
Stopping by the Woods on a Snowy Evening
Banks can’t pass the poison pig until its been fully digested, and a more active housing market is something that moves this process along. In the meantime, our American DNA is slowly changing. Tracking this change is interesting and predicting the effects of that change could eventually be of importance.
Right now, however, it’s like watching the woods fill up with snow. Lovely, fascinating. It might even be what really matters. But we have a long way to travel still. There’s a lot of mess to sort out. A lot of assets with uncertain values. An unknown economic future and unknown consequences of past and future government intervention. There are miles to go before we all can sleep.
We have promises to keep.
Today we wrap up our discussion on the current state of the housing market. Welcome to all the new readers that have joined during the last week! Parts one and two in this series are available if you want to get up to speed.
This week I have some more spooky stories and data, most of which will startle and disturb you. Lest I scare you away, be assured that there is a happy ending. This issue runs a little long, but this is really important stuff, the effects of which touch us all.
The Pig in the Python
I hate snakes, but this story creeps me out even more:
Certainly you’ve seen or heard of houses in your neighborhood that are sitting empty, where the previous owner, unable to make the monthly payments or unwilling to deal with all the negative equity, had simply walked out and left the keys on the kitchen counter. You might also have heard stories about people who have stopped making their monthly payments yet continue to live in the house. From what I gather anecdotally and economically, this is frighteningly common.
A couple months ago a colleague of mine was at a local event and he ran into a guy who was in a negative equity situation (this is Reno, after all), and he hadn’t made any mortgage payments in well over a year. Instead of completely walking away, he moved in with his parents and – get this – started renting out his other house! Not only was he not paying his mortgage, he was collecting pure income on the property!
Yes, that’s disturbing behavior, and probably illegal. But what’s almost equally disturbing is that the bank had done nothing about it. Things are really hazy in the world of banking right now, but how bad must things be where a mortgage can go 540 days past due and the bank not bother to take any action whatsoever to evict the resident or at the very least, make sure they aren’t renting it out on the bank’s dime!
I think it could have something to do with capitalization. When a bank forecloses on a house, it’s forced to mark that house to market, a value that is almost certainly lower than the existing value on its books. Write-downs like that en masse are disastrous for bank balance sheets, and with these entities on such shaky footing with such a delicate capitalization, I suppose it shouldn’t surprise me that they have been dragging their feet to resolve these problems. The last thing on earth these banks need is more widespread fear that they’re insolvent. That was a root cause of the mess a year ago.
Right now, this is the proverbial “pig in the python”. There’s a whole lot of fat and toxic waste on these bank balance sheets – some more than others – and it’s just going to take some time for that all to get digested and pass on through. It won’t happen overnight. Some of it will be nutritious, but, to extend the metaphor, this was a pig that was mostly poison.
More Pigs in the Python
And now for my next scary story, which some of you may have heard before. Below is a chart that was popular in certain concerned circles a year ago. It’s fairly self-explanatory.
That’s some heavy-duty rate-resetting taking place next year and the year after that.
Subprime is behind us. These were the loans put on during the bubble with ridiculously accessible terms for the first 1 or 2 years that would then convert to more conventional mortgages, the terms of which, would never in a hundred years make sense for those borrowing the money. Not that the bank that wrote the loan cared, as it had already been packaged and sold downriver, somebody else’s problem. But we’ve all heard enough of that.
From the chart, you can see that the next pigs in the python are Alt-A and Option ARMs. These are borrowers that aren’t technically subprime, but certainly aren’t quite prime, either. The economy has…changed a little bit since these loans were put on the books in the middle of the decade. Today’s Alt-A borrower might look a little more like yesterday’s subprime borrower than a lot of banks may want to admit.
Option ARMs are the “Pick a Pay” loans you may have heard of where the borrower can choose interest only, interest + principal, or a minimum payment like your credit card. They are primarily good credit score borrowers but the loans are mostly no-doc loans. A majority have negative amortization schedules or high loan-to-values. These are messy products.
There hasn’t been a lot of talk about rate resets this year because you can see that in 2009, relatively little is happening on this front. That will change next year and 2011. “Alt-A” and “Option ARM” aren’t quite buzzwords yet, but by this time next year they’ll be a part of everyone’s vernacular, though not to the extent that “subprime” was. There’s no question “subprime” has a subtly-malicious je ne sais quoi that “Alt-A” lacks.
Realtors: Not Optimistic
According to an eye-opening survey of real estate agents on home purchases and mortgage activity in the second quarter, short sales that require bank approval are taking an average of about 10 weeks right now.
There are countless other interesting tidbits in the 165-page report, but let me do the work for you and highlight the interesting ones. My comments are in brackets:
- “Down payment for mortgage” is the #1 impediment to first-time homebuyers seeking to buy a home. [This is not good for long-term housing strength.]
- The market for home purchases can be divided into segments of 26% for damaged REO, 23% for move-in read REO, 14% for short sales, and 36% for non-distressed properties. [Whoah. Nellie. 2/3s of all sales in 2Q09 classified as distressed!? Is this real demand for housing or just another facet of the public simply demonstrating an unwillingness to consumer unless they’re getting a “deal.”]
- 43% of homebuyers are first-time homebuyers. [From the homebuyer credit. As discussed, this is a temporary increase in demand.
Qualitative conclusions (with statistical support):
- Non-distressed property sells slowly at small discounts, most often to first time homebuyers and current homeowners; few investors buy non-distressed property.
- Short sales, while significantly discounted, sell slowly, most often to first-time homebuyers.
- Few current homeowners list their property for sale and/or buy another property except for relocation or under duress. [Somewhat disturbing that people are only buying/selling when they are forced to. Bad news for the aspirational upper end of the market.]
- The upper end of the housing market consists mostly of non-distressed properties that are initially listed at premium prices, but must be discounted to sell after lingering on the market. [Sound familiar?]
- Issues related to increasing mortgage rates are expected to grow in importance.
- Real estate agents view homebuyer tax credits as important in increasing home sale transactions and stabilizing prices, but in general, they favor time-based solutions to stabilize the housing market over financial incentives.
The results of this survey jive really well with what we’ve been talking about for the last few weeks. This is good data, too. Campbell Communications is in the business of conducting surveys, and there’s reason to take this information seriously. It’s reliable information straight from folks on the ground level.
Speaking of realtors…
The National Association of Realtors says you should buy a house
Not that you need more reasons to be skeptical, but does anybody remember these ads?
That’s from over a year ago. Home prices have fallen about 15% since then. Hope you didn’t buy a house on their recommendation! But seriously, who’s taking advice on housing from the National Association of Realtors? If you are, you deserve what you get.
Go ahead and call me a conspiracy theorist, but of course the NAR has a bias. Their core purpose is “to help its members become more profitable and successful,” which, given the existing compensation structure in Realtor-ville, can only be achieved through more home sales or home sales at higher prices. Could you imagine somebody like uber-bear Nouriel Roubini as the head of the NAR? I can’t picture it either.
The NAR’s Grand Poobah, chief economist Lawrence Yun, said a few weeks ago:
The housing market has decisively turned for the better.
There you have it. It’s turned for the better!
Now, this is a guy who not only denied there would be a recession in 2008 as many economists were revising their forecasts downward, but adamantly asserted that home sales and prices would remain strong through the year. Once the recession was officially declared and backdated to mid-2007, Yun said it would end rather quickly with unemployment peaking at 6.7% before steadily heading down and that home prices would – you guessed it – remain resilient throughout. Goodness gracious! It sounds like all the realtors around the country underneath him have a much more realistic view of today’s market.
I don’t mean to pick on Dr. Yun. It’s a cheap shot and hindsight makes that easy. As a fund manager, I know what it feels like being on the other end of that kind of criticism. A block of our lives is unavoidably public. We do the best we can with what we have, and a lot of times we’re just plain wrong. On balance, all the old hands in this business have really thick skin and are adept at learning from their mistakes. Those that don’t fall by the wayside and find jobs elsewhere.
Yun may have a very clear bias, and he may have been way wrong about a whole lot of stuff, but he is right about one thing: housing is key to sustainable economic growth.
It sounds trite, but rising home prices right now would solve a lot of our current economic problems. I point this out because endemic in that solution is a problem that’s very deflationary. This is why I think that all those that are super-freaked out about inflation are not only not living in the present, but too far out in the future.
Watch the health of this market. It will require diligence and effort to stay focused on this, because let’s face it, the future of the housing market is pretty boring. There is no money to be made (for the average person) in housing now or at any time in the next decade. But there is money to be made by the individual who stays tuned in to this market, and understands the effects it has on other markets and the global economy.
The stock market has rallied something fierce this summer, but that rally hasn’t been confirmed by the housing market. I know the stock market doesn’t revolve around housing, but 70% of the economy is consumer-driven, and consumer psychology has a lot to do with the health of the housing market. If I’m making strategic long-term investment decisions in the stock market, I’d like to see some legitimate strength in housing, though at this point I’d probably settle for a clear, definitive bottom.
A crucial disharmony
As something of a behavioral economist with a foot and maybe an arm in the Austrian camp, I’m very interested in monitoring the psyche of the consumers in this market. Right now, psychology in the housing market has suffered catastrophic damage after a near-fatal accident. How long until that’s been repaired? How long until the anchor of negative equity lifts and how long after that do we stop worrying it may happen again? How long until our homes make us feel wealthy instead of poor? This stuff is obviously very difficult to measure, but it’s of paramount importance to this market, and in turn, the global economy as a whole
When I talk to people about housing and ask them what they think about the future, I often hear things like “eventually prices will go up again,” or “now that it’s gone down so much it probably won’t go much lower.”
In a rational context these statements are, quite simply, false.
As we pointed out two weeks ago, prices don’t have to go up again any time soon. And the fact that they have fallen so far has very little to do with whether they’ll keep falling. Home prices are dependent on a lot of factors, but most importantly,
- How much current and future income individuals have available to allocate to a house.
- How accommodative the environment is to enabling them to pay more money for a house.
What makes all this really interesting is that when I talk to people about the broader economy right now, I do not hear the same optimism regarding incomes and the credit environment. Right now, most people seem to feel that the labor market is going to be a sticky slog for a long time and nobody seems to think aggregate incomes and wealth will increase the way they have in the last two decades. And who do you know that’s optimistic about the credit environment? Have you spoken with anyone who thinks that lower interest rates, lower down payment requirements, and lower credit standards are in our future?
The tiny psychologist on my shoulder wonders how people reconcile these two views. The one is so clearly dependent upon the other.
Perhaps I’m missing something. Markets of any type are heavily influenced by psychology, and efforts to understand this dissonance could be quite profitable. I wish I had the answers.
I see now I could go on and on. I haven’t even touched on rising foreclosures. More and more delinquencies from all types of borrowers (not just subprime). Historically high inventories and high months’ supply. Historically low lumber prices. The unknown ramifications of “Shadow Housing Market”.
Right before this letter went to publish, I discovered this from Whitney Tilson’s T2 partners; he went on for 155 pages so I don’t feel too bad about rambling. Tilson’s a pretty smart guy and a rational voice. He was on top the financial meltdown pretty much from the get-go. The report is worth your attention but the faint of heart should probably stay away.
I realize now I could have saved myself a bunch of time over the last three weeks and just linked to this report! Tilson does an embarrassingly better job with the material than I.
And now for something completely different
I promised you some good news, so we’ll close on a happy note.
Believe it or not, despite all my cynicism and skepticism, all of this mess actually gives me quite a bit of hope. Our national spirit has not been defeated.
Americans are remarkable creatures. Is there a more resilient, relentlessly optimistic body of people on earth? The United States is the greatest success story in the last 2000 years and it shouldn’t surprise you that given the track record of our country, our people should be so universally bullish about our long-term future. Despite our numerous failures and mistakes, we have emerged from each stronger, better.
Even during last fall as the world seemed to be crumbling around us (at least for those of us deep inside the financial industry), when I would talk about the crisis to people on both Main Street and Wall Street, the overwhelming consensus sentiment was: this is painful and scary, but we’ll get through it. It was almost eerie, listening to this mantra chanted over and over again, soothing our collective anxieties and reassuring our faith in one another. Really, we were all just in shock.
Today, in housing, activity has undeniably picked up. Yes, it’s primarily distressed sales at the lower end. Yes, it’s been driven in large part by incentives. Yes, the jumbo and luxury markets are still a mess.
But you know what? It’s better than a kick in the pants.
A bunch of new, performing loans are being written every day at terms that actually make sense for bank and borrower, straightforward loans with a much better equity cushion that improve banks’ prospects for long-term profitability and recapitalization.
As I mentioned earlier, the housing market is still stuck in this pre-Copernican mindset where it thinks that home prices are the center of the economic universe. They aren’t. The quality of the jump in sales activity may be poor, and this type of activity may not translate into stronger prices further down the road, but the quantity is good and the tangential effects of this increased activity are a positive thing for the economy at large.
So stop thinking about housing in terms of prices. Adopt a holistic view. I certainly hope I’m wrong about prices; I hope they stabilize soon and start trending upward. But there’s more value to be realized by thinking about what weak prices mean in a broader sense.
I think it means things like lower consumer spending and sluggish economic growth. It means less jobs for a long time in a lot of housing-related sectors, especially construction. It means opportunities will be highly bifurcated – there will be lots of good stocks to buy and lots to steer clear from. In late 2007, I adopted a blanket strategy of categorically avoiding financial stocks and anything too connected to the banks. With all the uncertainty and toxicity still floating around out there, I think that’s still a prudent thing to do.
Stopping by the Woods on a Snowy Evening
Banks can’t pass the poison pig until its been fully digested, and a more active housing market is something that moves this process along. In the meantime, our American DNA is slowly changing. Tracking this change is interesting and predicting the effects of that change could eventually be of importance.
Right now, however, it’s like watching the woods fill up with snow. Lovely, fascinating. It might even be what really matters. But we have a long way to travel still. There’s a lot of mess to sort out. A lot of assets with uncertain values. An unknown economic future and unknown consequences of past and future government intervention. There are miles to go before we all can sleep.
We have promises to keep.
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This is the second in our current series on housing. Part one is available here.
Last week we discussed the problem with negative equity and how sweeping it under the rug isn’t going to keep us safe from the ill effects it presents for the economy at large. This week we’ll take a hard look at incomes and the homebuyer credit.
Let’s get to it!
How much house can I afford?
We’ll begin with a simple exercise to illustrate the concept at the heart of this analysis.
STEP 1: What is your total annual household income?
STEP 2: If you had to buy a new house tomorrow, how much house would or could you buy? A $250,000 house? A $1.0 million house?
STEP 3: Divide that price by your annual income.
This is your price/income ratio. It’s probably somewhere around 3:1, right?
This exercise obviously won’t apply if you’re retired or are in a similar situation where you now have a lot of assets but not necessarily a lot of income. It also breaks down at the high end of the curve; if you’re in the market for a $5 million home, you probably aren’t earning $1.7 million per year. Maybe you are. I don’t know. If so, you clearly don’t need to listen to little old me! So just imagine that you’re somewhere in the middle of your career – just enough liquid cash for a 20% down payment and enough income to cover the mortgage and the rest of the monthly bills.
The neat thing about this calculation is that we can do it for the nation at large. At the end of the second quarter 2009, the median annual household income in the U.S. was $60,671 and the median existing home sale price was $181,711. This was a ratio of almost exactly 3:1. In aggregate and on average, people in the United States were buying homes that cost around three times their annual household income.
Over the long run, this is a ratio that stays somewhat constant. There’s good reason for it, too. Lenders typically won’t lend to you if they know you don’t have enough income to meet your monthly mortgage payments and homebuyers will typically buy as much house as they can afford. These two forces make for a rather natural equilibrium.
Most of the chatter one hears in the housing market centers on home prices, prices, prices, whether it’s existing home sale prices or the Case/Shiller price index. Every so often we hear about mortgage rates or the number of homes sold. But one thing that’s seldom discussed when it comes to housing is incomes. The level of one’s income – both current and expected – is a very important factor when it comes how much an individual will spend on a house. It’s probably the most important thing, so long we live in a world where banks require down payments and don’t lend money for free.
This is one of my favorite charts that I maintain one I wish I had in front of me back in 2005:
The recent jump in both price and price/income ratio is purely seasonal. We saw it last summer, the summer before, and we’ve seen it in pretty much every summer before that. The only reason that doesn’t appear on on this graph is because that data set is published annually before 2007 and so I had to smooth it to a monthly trend. (If anybody knows any good data sets for housing prices, please let me know!)
Looking at this chart makes a few things very clear:
First, home prices at the peak were flat-out insane and though we may all have felt that things were kind of expensive at that time, we really, really had no idea just how ridiculously overvalued residential real estate was by every metric imaginable.
Second, home prices right now in real terms still might be considered moderately overvalued. In other words, the blue line has room to go down. Over the long run the chief driver of home prices is inflation, so when you factor inflation out, prices are fairly stable. They only really go up when aggregate wealth and incomes are increasing in real terms, or the environment is changing in a way that makes it easier to pay more money for a house. Things like the popularization of the 30-yr mortgage, the tax incentives of mortgage interest, and the expansion of lending to those who previously had no access to credit i.e. subprime lending. All these environmental changes allowed people to pay more money in real terms for a house.
Taking away those things would add downward pressure to home prices. Can you imagine what requiring people to pay cash for a home would do to prices? What if Congress changed the tax code so that nobody could deduct mortgage interest on their tax returns? The last decade was an eventful one. Very quickly it became very easy to pay a lot of money for a house and then even more quickly, all those things that made it so easy to pay a lot of money for a house were taken away.
The price/income ratio is much more reasonable today than it once was, though it’s still about 5-10% above the long-term (ex-bubble) average and nowhere near historic lows or the lows we saw in the 1991 recession. Factor out the steroidal effects of the credit bubble and homes are still more expensive relative to incomes than they have been in 25 years. Kind of a scary thought, no?
You’ll notice a jump in the price/income ratio in the early 80’s, but that wasn’t because real house prices went up (they actually went down!) but because incomes fell by so much during that nasty recession.
Incomes haven’t fallen so much during this recession but it’s interesting to note that they have been flat-lining for the last decade. I know you didn’t need another reason to convince you that everything since the dot-com bubble has been financially-engineered smoke and mirrors, but there it is.
Given the massive hurdles our economy now faces and a historic scaling-down of the labor market that will likely continue for a while, do you really think incomes are primed to rise?
With banks failing all around and others curbing their lending dramatically to reduce risk, does anybody out there think that credit will magically become easier to obtain? Think the 2%-teaser 0%-down mortgage will make a comeback?
Because of the collapse in the stock market and real estate market, American household balance sheets aren’t looking too great. Households are still overleveraged, too heavy on the liability side and stuck with assets that are worth a whole lot less. Net worth is way down which means less money for a down payment which means less people buying houses which means lower prices. That doesn’t even begin to address the psychological effects that reduced net worth also brings.
I have a very hard time believing that home prices will “recover” here, much less even begin to trend back upward.
Should I buy a house?
Sorry folks, but there still could be another 10-15% downside in home prices.
I know. That sounds crazy. Another 10-15%? It’s clearly possible from a technical analysis perspective.
When you realize the bubble in that chart (which was deceptively slow to form) was completely bogus and based on easy finance and lax lending standards, and add on top of that all the current fundamental problems with real estate right now like massive excess supply, and add on top of that the economic headwinds our nation will be up against over the next decade, another 10-15% drop starts to sound more reasonable.
A drop like that isn’t quite so scary on its own, but given the complete lack of upside in housing it should give you nightmares as an investor. I try and read as much material as I can from as many different viewpoints, but I’ve yet to come across any reasonable arguments for significant appreciation in home prices. Call me a Negative Nancy, but I think stabilizing prices are a best case scenario for this market.
That being said, if:
- You need a place to live.
- Plan on living there for a long time.
- Have good credit and can easily afford the monthly mortgage payments.
you have my blessing to venture forth and buy a house.
The Homebuyer Tax Credit
Speaking of buying a house, check this out:
NAR estimates that about 1.8 to 2.0 million first-time buyers will take advantage of the $8,000 tax credit this year, with approximately 350,000 additional sales that would not have taken place without the credit.
OK, current and future taxpayers, that’s about $16 billion you just spent to spur home sales. That’s roughly $45,700 per additional house sold. Hope it was worth it!
Before the bubble, back in the 90’s, existing home sales would run around 4 million per year. As the bubble was inflating, sales would run about 5 million per year. During the peak, existing home sales topped out at over 7 million per year! In 2009, sales have averaged at about a 4.7 million annual rate.
Incentive programs like the homebuyer credit typically have the effect of pilfering future demand and transferring it to the present. That’s not always a bad thing. But people don’t buy houses the way they buy milk. Inventory turnover in the housing market is very, very low relative to other goods. Does this mean that home sales in 2010 will clock in 350,000 units below 2009, so long as everything else stays constant? Not quite, but within that 350,000 additional homes that were sold is a certain number of people who were on the fence and looking to buy a house at some point in the future. Those folks did it this year and won’t next.
I mentioned above that environmental changes that enable individuals to spend more money on a house can positively impact prices. It’s difficult to measure, but the Homebuyer Tax Credit has unquestionably had a positive effect on prices. How could it not? With the current median existing home sale price where it is, that credit amounts to a 4-5% discount! Keep in mind, however, that this is not a permanent shift in the environment. Any positive effect this has had on prices will be short lived.
More broadly speaking, it’s disturbing that individuals seem so reluctant to spend unless they’re given a freebie in the form of a government incentive like this homebuyer credit or cash-for-clunkers, or a midnight sale. That’s very deflationary when it comes to prices, and I wouldn’t bet on retailers regaining significant pricing power any time soon. Assume for the sake of argument that the U.S. consumer is in dramatically better shape to begin calendar year 2011. Will he have forgotten the trauma of ’07-09? Will he be willing to pay full price for the goods he so recently was purchasing at significant discounts? Tough to say for sure.
At least it’s stimulating…sort of
Any way you slice it, that’s still about $16 billion of stimulus. $16 billion is a lot of money, but it doesn’t really move the needle of a $14 trillion economy. Families will get that $8,000 back after filing this year’s taxes and then what will they do with it? The last time Captain America handed out free money, in early 2008, people wound up saving most of it or paying down debt. Maybe this time they’ll spend it.
Either way, the effect is temporary. Policies like this don’t make the economy any stronger over the long run, they won’t create new jobs, they won’t keep putting money in people’s pockets, and they won’t keep home prices from going to where they ultimately need to go.
Whether the stimulus was the right thing or wrong thing to do is best left for another debate in another forum. My generation has the rest of our lives to figure this out and come to a conclusion whether all the costs were worth it. None of that is going to get answered today.
To bring the discussion back to housing and summarize: the credit is unquestionably positive for prices over the short run and unquestionably negative for prices beyond that, but in the grand scheme of things it probably won’t matter all that much.
It’s like eating a Snickers bar. It tastes great and gives you energy for the next hour or so but then comes the crash and the extra fat your body now has to deal with. Tomorrow we will have forgotten about everything aside from what it cost us.
Market Recap
It seems like I mention every week that the recession is technically over but that it’s not going to feel like it for a long time. Look around: on the one hand you have a majority of economists claiming that the recession is over while a majority of normal people (trust me, economists are anything but) saying that the recession is still here. Those two articles are a beautiful illustration of the point I’ve been trying to make all along.
I’m not sure what else I can say about the stock market right now. I liked it over the very short run last week and after the rally since then I don’t like it so much anymore. Traders, feel free to buy the market – it’s certainly the trade that’s working right now – but do it on dips and keep a stop. The short term trend is up so don’t fight it.
Investors, you know how I feel. If I was forced at gunpoint to go long the market, I’d at the very least try to stall and drag my feet until November. After that, I’d be very selective about the stocks I purchased. Trash has led the way since March, and rather than chase it, I’d prefer to go back to boring companies with good balance sheets and juicy dividends. Those names will outperform in environments where investors’ risk appetite dries up.
The Dow closed at a little over 9600 today. It might keep going up from here or go back down. Regardless of which path it takes and how far it travels, I think at some point in 2010 or 2011 or maybe even 2012, we’ll all have the chance to buy The Dow again at 9600. Until then, or until the fundamental facts change and the market’s valuation or dividend yield improves, I’ll be doing something else with my money. Gimme corporate and agency debt, munis, treasuries, cash, commodities, or hedge funds instead.
I speak of all that somewhat academically, of course. The overwhelming majority of my liquid net worth is invested in our business and the funds that we manage. Always has been and always will be. (Always should be, if you ask me.) But I do have some other accounts here and there, and if you find it helpful or interesting, I’ll let you know where I think I see some value and have backed up that claim with actual money.
Gold, Gold, Gold!
The big story in the markets during the last week has been gold, making another run towards $1000/oz.
My technical analysis brethren should recognize the bullish pennant, and for the uninitiated, bullish pennants are, well, bullish. I don’t have the answer to where gold goes from here, which is the question everybody seems to be asking right now. I’ve liked and owned gold – both physical gold and via GLD – for a long time, but not for the reasons you might be thinking.
Traditionally, investors flock to gold as a hedge against inflation, though it only effectively does that over the very-long run. Others buy it for post-apocalyptic reasons, to prepare for a gritty, windswept landscape where fiat money is worthless and only those with the best-stocked bunkers survive. Some, like my lovely and fashionable wife, buy it because it’s shiny.
I won’t ever give you a hard time for owning gold for any those reasons, but the one reason that everybody really needs to own a little gold is that it behaves in a radically different manner than basically every other market. Investments that are different are desirable because they give you true diversification.
Guys, maybe you never looked at your wife’s jewelry this way before. The gold I buy, I plan to sit on for a long time. Does it make that much difference if it’s in my safe or draped around my wife’s neck? [EDITOR’S NOTE: that statement is probably going to cost me some money.]
In practice, I recommend buying and holding gold because trying to trade it will drive you bananas. Gold never moves the way you think it will. It never tells you what you think it’s telling you. And it does strange things for even stranger reasons that no sane person can hope to understand. Investors who own gold for the long haul love it, but I’ve yet to meet the trader who hasn’t been driven completely insane by the gold market at some point in his career.
Humans have had a love affair with gold since the dawn of organized society. After a recent trip to Alaska, I picked up The Klondike Fever by Canada’s beloved journalist, historian, and television personality, Pierre Berton. It’s the definitive work on the Klondike gold rush, and while this brief window in time may appear bizarre on the surface, the insights into human nature are fascinating and applicable even today. I can’t recommend it enough to history buffs, gold bugs, or anthropologists.
That’ll do it for now. Next week I’ll wrap up our discussion on housing with a few more interesting tidbits about the housing market which may surprise you. I’ll also look at some things that might actually be positive for the market. Then we’ll see if we can find some investing strategies; perhaps there is a way to make a buck or two off the mess in housing.
See you next Thursday!
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Today we’ll embark on a little journey through the current housing market. There’s been a lot of hubbub in this sector lately and at long last (phew!) some legitimately good news seems to be emerging. As usual, the story is both more complicated and simplistic than it seems at first blush. I’m going to cut through a lot of the noise and during the next couple of weeks I’ll bring into focus a few things that really matter.
This is exciting stuff. Buckle up and let’s get this show on the road.
Is the crash is over?
The term “crash” in the housing market takes on a slightly different meaning. Suddenness is the key dynamic in crashes of any sort, and in real estate nothing happens suddenly. The housing market has been “crashing” for two years now.
Recently we’ve had slight increases in existing sales, a slight increase in the Case/Shiller Home Price Index, and a slight increase in median sale prices. Prices and home sales typically rise during the summer months so a lot of this is seasonal and a lot has to do with a decline in distressed sales. Let’s everybody hold their horses until we move through winter.
But the good news is that the crash is probably over, not because of these flimsy data points, but because valuations are finally entering a range that makes some sort of sense. I’m certainly not saying that real estate can’t go lower from here (in fact, next week I’ll show you that it can), just that there is finally some light in the tunnel in the form of price stabilization and I don’t think that the next 12 months will look like the last 24. Those of you buying a house today are not going to get burned the way people who bought houses in 2005 and 2006 did.
The bad news is that there isn’t going to be a recovery in the sense you might be expecting. Those of you buying a house today are not going to be rewarded the way people who bought houses in 2000 and 2001 were.
Have a look at this:
Well, does it? Does that chart make you excited?
That’s a 20-year chart of real housing prices before the bubble.
Guess what. Now that the finance-bubble has popped and real estate has fallen to more-sane-but-not-cheap valuations, it’s a good bet that the next 20 years of housing prices will look very similar. Yawn.
I don’t mean to sound flippant, I’m simply trying to illustrate that the days of our obsession with home prices are quickly coming to an end. Ten years from now nobody is going to be nearly as concerned as they once were with whether their house went up or down in value over the previous 12 months. This will be the indirect result of the stabilization.
During the dot-com fallout we needed something to cling to, an “investment life raft” that was reliable and easy to understand, something that would soothe our psychological anxiety as the stock market was crumbling around us. The result was a wave of personal finance literature about how one’s home was actually one’s biggest and most important investment. The artificially-low interest rate environment simply added fuel to the fire, as did cherry-picked data that gave people the impression that home prices never went down. Those nasty little seeds would later give birth to perhaps the greatest bubble in history.
Your home is not an investment in the typical sense. It’s a mechanism for forced savings and always has been for most of the entire history of real estate prior to the early 00’s.
During the bubble we forgot all about that and it empowered us to do ridiculous things. Maybe we traded up and transferred all that savings to a bigger house with a bigger mortgage. Maybe we tapped some of that savings with a HELOC and used that money on… a new boat. It was an investment that always went up!
But prices started going down and wiped out all the rest of the savings we’d accumulated whether by 30 years of steady payments or the rapid increase in price during the bubble. I realize that has been rehashed elsewhere ad nauseum, but it brings me to my next point which hasn’t quite been getting the attention it deserves.
Negative equity is a serious, serious problem right now
Just because the crash is over doesn’t mean real estate’s woes are in the rear view mirror. Far from it. In fact, we’re now just getting to the really tricky part.
It’s estimated that right now around 15 million homes are worth less than the mortgages on the properties. That’s about a third of all mortgaged homes. Yikes! Here in Nevada, about 66% of homes are estimated to be in a negative equity situation. Sure, much of that is Las Vegas’ problem, but up here in Reno it’s still a legitimate issue. Deutsche Bank recently estimated that the number of homeowners with negative equity could approach almost 50% by 2011. Double yikes!
This is a massive, massive problem for the banks and entities that hold the other side of these mortgages. Who knows how they’re accounting for them on their balance sheets. Who knows what that’ll do to their earnings, the financial system, and the market/economy at large if and when they start writing more of that stuff down. Banks are very clever. All that bad debt isn’t any better today. Some of it may have changed hands, but it hasn’t gone away. Bad debt doesn’t just disappear; somebody pays.
On the individual level, negative equity is a big problem because it makes people feel poor. Not enough people in this industry gave the wealth effect our nation felt during the housing boom enough credit for the way it drove consumer spending and thereby fueled GDP.
This was a favorite chart of mine from a few years back:
Not exactly a shining endorsement of the U.S. economy in the early 21st century. Things have been much worse over the last decade than we may have realized. Public policy and the financial environment has basically amounted to “giving the kid more candy to keep him from getting cranky.” Parents know that usually ends with tears all around. But this is how we like to solve problems in the U.S. We are a nation hypersensitive to short-term pain and democracy gives us the power to vote ourselves what we wish whether it’s in our long-term interests or not.
To the matter at hand: it’s not too simplistic to say that nearly all the economic growth we enjoyed post-2001 was due to home equity credit extraction. All this is very consistent with Friedman’s permanent income hypothesis which I’ll break down for you as follows:
- We expected our homes to keep rising in value.
- We felt more wealthy.
- We spent more as a result.
Now, reverse that within the framework of a falling or even flattening real estate market, and it adds up to a consumer that’s much less comfortable spending money.
As the son of an arch-conservative, fiscally-hawkish commodities trader I suppose it was impossible for me to ever grow up into a man that wasn’t compulsively obsessed with the concept of value. I would never have called myself a big spender to begin with, but after the last year, even I am noticeably more careful with how I spend my money. I’d wager that – regardless of your situation and where you’ve come from – today you probably feel the same way.
Tell me that’s not a huge drag on economic growth.
How do we solve the problem?
If you think about it logically there are really only two solutions to the negative-equity problem.
- OPTION A: Housing prices re-inflate substantially (think 50-100%), which is flat out ridiculous.
- OPTION B: The value of these mortgages need to be marked down and the lien holders i.e the banks eat the loss. It’s equally ridiculous to do this all at once given the chaos of last fall.
There have been a variety of proposals in between those scenarios that have been suggested, and the path that we seem to be travelling seems to be closer to Option B since that’s the only one that is at least somewhat realistic and the only one that anybody has any sort of control over.
During the crisis of 2008, the decline in value of housing relative to the debt against it and the myriad derivative contracts stemming from this problem made many, many financial firms technically insolvent. That was when Captain America flew to the rescue and controversially used public funds to recapitalize (“bail out” if you prefer) these insolvent firms. Step two was to create an environment where banks could be extremely profitable and then use those profits to slowly offset the losses associated with all this stinky debt. When these banks started making tons of money in Q1 and Q2 this year, this too was controversial.
Eventually, all that debt will be worked off and replaced with better debt. That’s how banks handled the last debt crisis, and it’s how they’ll handle this one. But it’s like dieting. Losing weight takes time and dedication, and it isn’t much fun. I recognize that we are a nation obsessed with quick fixes, but it’s impossible to clean this mess up overnight.
We all may stop caring so much about home prices, but the state of this market will have major economic implications for a long time. Hence, the “New Normal” that I’ve been discussing here for months now, and that’s also been discussed (in far more elegant, effective language) elsewhere. Life is no longer easy for investors.
A nose for real estate
I have a 3 year old Westie named Bishop. As a fellow schedule-oriented creature, he looks forward very much to our afternoon walks every day from 3-4pm after I get home from work. Our neighborhood is typical tract housing. It’s a nice neighborhood in one of the nicer parts of town, but it’s modern tract housing nonetheless.
During the first year of our walks around the neighborhood it seemed like just about every house was for sale – no joke, 5 or 6 for sale on a street of a dozen homes. This, of course, was 2006, right near the peak. Something wasn’t right and I’d guess that at that point even my new puppy had a better idea of where real estate was headed than a lot of the crazies that were trying to flip this and that.
By mid-2007, the “For Sale” signs slowly started to disappear, but that’s when the real problems were beginning. Stocks (always a leading indicator) started going down and margin desks around the world started calling in leverage. Construction on the new development to our east stopped immediately. Bishop didn’t mind, never really a fan of the noisy dump trucks and bulldozers. But no more dump trucks would mean no more people getting paid to drive them. What consequences would this have? Neither of us were exactly sure.
By mid-2008, the neighborhood was dotted with one or two dead lawns per cul-de-sac. Weeds had overtaken other properties. Most of these houses were built between 2003 and 2006 and by 2008 had been nearly halved in value. I bet Bishop a bag of Pup-Peroni that well over half of all the mortgaged houses here were under water. He just cocked his head and looked at me funny.
Today when we walk around the neighborhood, things feel a little better. There is what seems like a normal number of houses for sale. But there are still empties here and there, and still a few weed-infested, dead lawns. Some of you may have had experiences like this, but it’s likely that this is still a regional phenomenon. Until these vacant or distressed houses sell – not all of which are technically listed for sale, mind you – the housing market will not have found its bottom. There’s still simply too much supply on the market and counting on an increase in demand to clear this condition is a shaky proposition. I doubt even Bishop would take that bet.
The point, though, is that these houses aren’t appreciating in value. They were built in the middle of the boom and bought with little money down. Virtually every house that sells in my neighborhood today does so at a price less than the mortgage associated with it. Somebody eats that loss, and no accounting legerdemain can make that write-off disappear from a bank’s financial statements. Unless, of course, the bank in question is Goldman Sachs.
Lookout, here comes September
Since I mentioned my fear at others’ greed last Thursday, the S&P 500 fell four days in a row for a total of about -3.75% before bouncing a little today. It’s the worst drop in the market since early July, and over the short-run, a day like yesterday makes for a compelling entry point. Beyond that, it’s a different story.
I’ve noticed an increase in media stories about volatility during the fall months or that September is historically the worst calendar month for performance or that most crashes have occurred in September and October. A lot of that has to do with our proximity to the events of last fall and our natural wont to fixate on past performance and project it into the future. Last fall was a disaster and therefore people expect that this fall will be the same.
That forecast is incorrect. But there is a separate, legitimate pattern here. I couldn’t find much reliable data out there on this so I had Kelsey (who manages The Draconian’s distribution) put together our own study. We took a look at average historical returns by month for the Dow Jones Industrial Average since 1928 which covers a wide range of economic conditions. We also threw in some bonus data for you folks that really like numbers. You know who you are.
|
Month
|
Average
% gain/loss |
% Profitable
Months |
Std. Dev.
|
Worst Month
|
| January |
+1.13% |
66.7% |
4.8% |
-8.8% |
| February |
-0.06% |
54.3% |
4.2% |
-15.6% |
| March |
+0.29% |
59.3% |
4.7% |
-23.7% |
| April |
+1.37% |
56.8% |
6.2% |
-23.7% |
| May |
-0.20% |
53.1% |
5.3% |
-21.6% |
| June |
+0.58% |
50.6% |
5.5% |
-17.7% |
| July |
+1.37% |
61.7% |
5.2% |
-10.7% |
| August |
+0.79% |
62.5% |
6.1% |
-15.0% |
| September |
-1.45% |
40.0% |
5.8% |
-30.7% |
| October |
-0.01% |
56.8% |
6.1% |
-23.2% |
| November |
+0.75% |
59.3% |
5.5% |
-14.0% |
| December |
+1.41% |
72.8% |
3.7% |
-16.6% |
September has not been a good month to be in the market. It has the lowest average monthly return, the fewest number of profitable months, one of the highest volatilities, and also is the home of the single largest monthly drawdown.
For what it’s worth, unless there’s a major exogenous event, I think the odds of a crash are very unlikely here. But I simply do not like the market at these levels for any horizon beyond the next week or so, not on the heels of such a strong summer and not with the economic headwinds 2010+. I don’t think another 5-10% pullback over the next few months would surprise anyone in the industry, and a lot of times these prophecies can become self-fulfilling.
I have plenty of reasons to stay out of the market right now, but if you’re nervous going into this fall, the time to get out is right now. Check back with the markets in November and see where we’re at. As you can see in the table above, November through January is usually a pretty good time to be long the market – a high probability of good returns with low volatility. There are fundamental reasons for this too, which I’ll illustrate when the time comes (and I’m not running long).
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