TFTF

The Housing Bubble Blues

August 30, 2002

Housing, deflation, bonds, and the dollar are all inextricably linked, if you connect the dots between numerous studies which have come out in the past few weeks. We'll do that and more as we explore the implications of even a small housing bubble and what it will mean to you.

I frequently get email from readers asking whether they should buy or sell a house in a particular area. The short answer is, "I don't know." Today I am going to give you the tools which will help you answer this question for yourself. Plus, the analysis will have implications for the rest of your investment portfolio.

The Weakest Link in Housing Prices

I came across a study by Dean Baker of the Center for Economic and Policy Research (http://www.cepr.net/). It was titled: "The Run-up in Home Prices: Is It real or Is It Another Bubble?" While the CEPR is clearly a left of center think tank, the basic data and analysis in the study is rather straightforward and solid analysis. Baker was kind enough to speak with me on his study and offer some further insights. I think you will find his analysis very instructive.

Baker shows that there is a strong long term connection between the rise in the value of homes and inflation. Every other variable, such as interest rates, demographics and income has a tenuous connection. Over the long haul, the national average of the value of housing rises in tandem with inflation. This makes a certain logical symmetry, and thus I tend to give this relationship some credence.

Home purchase prices have risen nearly 30% more than the rate of inflation over just the last 7 years. This is a clear break with the trend. This has increased the net worth of homeowners in the US by $2.6 trillion dollars, compared to what would have happened if the rise in homes had been in line with inflation. As we will see later, this was a big reason for the growth of the economy in the 90's.

For Baker, the implication is clear. Housing prices are likely to come back to trend over time. Either this means falling home values, or no rise in home prices as the trend in inflation catches up to current home prices.

There were a number of interesting findings in the study. I have always assumed that part of the increase in the price of homes was the willingness of buyers to devote a larger portion of their income to housing. This was true in the 70's and 80's, but the growth in the percentage of income devoted to housing in the 90's was quite small.

"Two thirds of the run-up in home prices is attributable to a rise in the price of buying a home relative to the cost of renting a home..... This is what would be expected if there is a housing bubble, since it suggests that families are buying homes in large part as an investment rather than primarily as a place to live. A sharp slowdown in the rate of inflation in [the] rental cost index in the last six months, and a record high rental vacancy rate, suggests that demand for rental housing is lagging, which could precipitate the collapse of the bubble."

He examines the effect of collapse in housing prices back to trend. It would likely drop housing prices somewhere between 11% and 22%. This would destroy between $1.3 trillion and $2.6 trillion in housing wealth. Since about 6 cents of each dollar increase in home values shows up in consumer spending, this is likely to reduce consumption by $80 to $160 billion, which is a huge drop.

Finally, the home owner's equity to value is now near its all time low of 55.2%. This will clearly get worse if home values drop. It could go as low as 42%. This would have large implications for the homebuilding industry. Baker estimates it would drop new home building by $63 billion to $136 billion annually. Again, this is another potentially huge drop in GDP.

I asked him point blank, "When do you see this drop beginning?" He pointed out that he thought stock prices were too high in 1998, but they continued to rise. Picking a date for a bubble to begin bursting is difficult, at best.

Is There Really A Bubble?

I argued a few weeks ago that housing prices are nearing their peak, as the growth in personal incomes is a limiting factor in their rise. You can only spend so much on housing. The study shows this to be the case.

For me, there is a clear implication that the drop in interest rates has allowed home owners to buy more home for the same payment, and they have done so, considering homes as an investment as well as shelter. Homeowners (on the national average) are not really spending a significantly higher percentage their income on housing

Baker makes the case that interest rates do not explain the rise in home values, as much sharper interest rate moves in the 80's did not have anywhere near the same effect.

At this point, I part company with Baker. I think a significant portion of the rise in home values can be attributed to lower mortgagee rates. While I agree with Baker that there is no seeming historical connection between interest rates and home prices, I think there is clearly a link in the last few years. There is a natural limit to this, however, as mortgage rates can not go down all that much more.

Thus, I think we are close to the top in terms of the growth of housing prices. When you couple this with Baker's connection between inflation and home prices, there is the clear implication that we are near the end of this rise, and the best we can hope for is to stay where we are.

Now, is this rise in home prices a bubble? If you do a comparison to the tech bubble, as illustrated by the NASDAQ, it is not. Homes are not overvalued by 4 times.

But when you look at the leverage employed, the concern grows. A 10 or 20% drop in home values would put a lot of home owners in a negative equity position. A recession would increase unemployment, and would result in an increase in the foreclosure rate. Think Houston in the late 80's if you want to think of the worst possible situation.

Should I Stay Or Should I Go?

Now, let's see if I can give you some ideas in thinking about your home. Whether or not you are thinking about buying or selling, you have friends or family who are, and this may be useful to pass on to them.

First, buying or selling a home should be part of an overall life plan. If you don't know where you are going, how can you know what path to take? No matter how good a deal a home might be, if it keeps you from accomplishing your overall plans, owning a home could be a problem.

If you buy a home today, you must be prepared for the value of that home to drop over the short-term. I would not buy a home with a view to selling within a few years. The risk at this point in the cycle is high that the value of your home could drop. If you plan to live in that home for 10 years or more, then your risk is much less.

While I have argued for years that we are dealing with deflationary forces throughout the world, and a drop in the US housing market would be a big deflationary force, I don't think that deflation will be the ruling paradigm long-term. We will see a return to inflation. If Baker is correct about the relationship between inflation and home values, and there is much evidence to suggest he is, then over time, even if your home suffers a temporary drop in value, it will rise again.

Is it unreasonable to think we could see 25-30% inflation over the next 10-15 years? I don't think so. That is not much more than an average of 2.5% a year. That level of inflation would bring home prices at their current level "back to trend."

Now, all real estate prices are local. You can go to Baker's study and look at Appendix 1. You can see how much home prices have risen in your state. Not all states and all areas have seen a strong rise in home prices. If your area is growing, and likely to continue to grow, and you have not seen a large growth in home values, then it would be much safer to buy a home and expect to see it rise over time.

If you are thinking of buying a home as an investment, with some regional exceptions, this might not be a good time if you have a short term view. Right now, vacancies in rental property are at 9%, which is quite high. The growth in the cost in renting is almost nil. This is a limiting factor on the rise in home values, and certainly on the cost of comparable rental property.

If you can rent a home (on a monthly basis) in your area for a lot less than you can buy it, especially with today's low mortgage rates, that is a sign the price of homes in your area is getting ready to stumble.

If you are planning to retire in a few years, and are counting on selling your home and using the profit as part of your retirement plan, then you want to think about what would happen to those plans if your home dropped in value. Baker points out that areas where homes have appreciated the most will see the most drop in value. A drop in the national value of homes of 10% could mean that some areas see 30% or more. If that would put your retirement plans in jeopardy, then you need to think whether or not you want to take that risk.

A serious recession, and it is highly likely we will see one this decade, would put pressure on the ability of homeowners and renters to pay. In Houston in the 80's, most people had jobs throughout the local slowdown. But enough people were thrown out of work that housing prices dropped precipitously for a few years, until the local economy recovered. At one point, you could buy homes at auction with your credit card.

As an example, San Diego is one of the most desirable places to live in the country. I love the area. Would an economic slowdown have an effect on local prices? In San Diego County, 1 in every 5 renter households spends at least 50% of its income on housing, and 13% of homeowners spent at least half their income on their mortgage payments in 2000. That is not a prescription for stable home prices in a severe recession. If you own a home in San Diego that you wanted to keep for the next 10-20 years, then I would not worry. If you plan to sell within 2-3, then you should think about selling now.

I cannot urge you strongly enough to formalize your investment and retirement plan, and to think through the implications of what part your home plays in that plan. If your plans relies on the value in your home, or on 5% annual growth in the value of your home over the next 10 years, the data says your plan may be in jeopardy.

For the record, I sold my home a few years ago, and now rent. I think both home prices and interest rates will come down from where we are today. I will buy again, but because I want to own a home in a particular area for the long term, and do not care about the up and down values in the short term. Of course, I hope to wait for a good value.

The Implications of a Drop in Housing Prices

Stephen Jen and Fatih Yilmaz, in the London branch of Morgan Stanley, recently did a study on the "Asset and Monetary Conditions Index and the US Dollar." They were trying to show what effect that property values, interest rates, the stock market and the value of the US dollar has on consumer demand.

They make a few very important statements. First, by their calculations, property wealth (the value of US homes) is more important than stocks, interest rates or the value of the dollar COMBINED in its effect on consumer spending. (Emphasis on the word COMBINED!)

Using an entirely different approach, they come to much the same conclusions as Baker as to their concerns about the effect of a drop in housing prices on the economy. Secondly, they worry that the effect that property values, equities and interest rates have on aggregate demand by consumers has already "maxed out."

That leads them to the conclusion that the value of the dollar is in doubt. Let me quote at length:

"The fate of the US consumer depends, in part, on the outlook of the property market. The risk profile for properties is two-sided. On the one hand, if the long bond yield continues to be depressed, reflecting dis-inflationary expectations, or from safe haven capital flowing into US Treasuries, the property markets could be supported longer than many people think, and, in turn, support consumption in the US. On the other hand, property prices could also fall. We need not go into too much detail on the familiar arguments, but only to point out that if property prices experience a meaningful correction, it would lead to a significant tightening in [the conditions for growth] in the US. Since the other factors are 'maxed-out,' a correction in property prices could force the US to re-consider its strong USD policy. We should underscore that we are not suggesting that the US would explicitly adopt a weak USD policy; this would be too dangerous for bonds and other assets. What we are suggesting is that there could be a further softening in the definition of the strong USD policy."

The unwritten implication in the above analysis is that even if low mortgage rates support the housing market for a longer period of time, that sooner or later a reversal will come.

Now, let's jump to Greg Weldon's latest letter, written from his vacation. (Some people just can't rest.) He notes that the mean price on new homes is down 5.4% in just two months, and the median price is down over 8% in just the last two months. While sales have risen over the past month, they are down from a year ago.

Two months do not make a trend, but this price action bears watching.

Let's think through some of what we just read. The most important factor which influences the growth in consumer spending is the value of their homes. We are bumping up against the limits in the rise in home values. According to Baker, even his most modest prediction of a drop in home values would result in a recession and an increase in unemployment by 0.75%.

Baker paints it in stark terms: "At present, the economy is also badly in need of the stimulus that would be created by increased net exports. In the wake of the collapse of the stock market bubble, investment spending has fallen by an amount equal to approximately 1.2 percent of GDP compared to its 2000 peak. With the collapse of the housing bubble, housing construction is likely to fall back by 0.6 to 1.3 percentage points of GDP. If the savings rate were to return to just 5 percent, approximately half its historic average, then it would lead to a falloff in consumption equal to approximately 2 percentage points of GDP. If the savings rate rose back to its historic average (which would be desirable with so many baby boomers nearing retirement), the falloff in consumption would be close to 6 percentage points of GDP. The shift from a federal budget surplus to a deficit is an important source of stimulus in this situation, but there will be a need for considerably more stimulus. Without a sharp reduction in the trade deficit, it is hard to see how this can come about."

I will leave aside his point about the stimulus from deficits for another day, but he draws the same conclusion that the Morgan Stanley study does. There will be a clear need in the near future for a drop in the value of the dollar. This is apart from the pressure on the dollar from the trade deficit. The two combined will move the dollar down even more.

I have been suggesting that investors look at investing in euros and other foreign currencies since the early spring. You can buy a CD in a foreign currency at a US bank based in St. Louis called Everbank. Talk to Chuck Butler at 800-926-4922 and tell him I suggested you call. He can send or email you information about their offerings. The euro is back down below a dollar, in the $.98-.99 range. I think $1.10 is very possible over the next year or so. There are other analysts who see a much more dire drop in the dollar, but considering how rapidly the rest of the world is slowing down, especially Europe, it is hard to imagine a precipitous drop. Still, a 10 % drop, plus interest, could be a nice investment, and I don't think there is too much downside risk to investing in euros at today's prices.

A second implication of a drop in housing prices is a further drop in long term bond rates. I predicted a drop in long term rates at the beginning of the year, and since then my favorite long term bond fund, the American Century Target 2025, is up over 14% and had another very strong day as the yield on 30 year bonds dropped to 4.93%. 10 year rates have dropped to 4.14%. Since 30 year mortgages are barely under 6%, and there is a strong link between mortgage rates and 10 year Treasury bonds, it is likely we will see a further drop in mortgage rates over the next few weeks, if the downward pressure on interest rates continues. 15 year mortgage rates are now at 5.36%. I wrote in 1998 we would see 5% rates, and we are getting close.

A drop in housing prices will inject very large deflationary pressures into the US economy. The Fed will do what it can to help rates go lower in an effort to forestall such an event. Either way, through Federal Reserve "help" or natural deflationary forces, there seems to be downward pressure on long term rates. This volatile investment is not for the faint of heart, and not for a large portion of your net worth. That being said, I think there is still a nice potential profit in this market.

Third, the Euro-dollar market is pricing in a rise in Federal Reserve rates over the next year. Given the weakness of the economy, and the fragility of the housing markets, I have trouble seeing where Greenspan is going to raise rates. I wrote almost 18 months ago that Greenspan had made the last interest rate increase of his career. I still think that may be the case, unless he does not retire in 2004. Just as I wrote last year, once again futures traders can take this trade and bet against rate increases. I think it will make money once again.

Where We Are Today

The economy still bumps along. The Chicago Purchasing Managers Index was up sharply, suggesting that August saw a nice growth. Retail sales are soft, but have not fallen off the table. All in all, we are still in the Muddle Through Economy, and I think we will be, until the scenario of falling house prices described above takes place. This year? Next year? 2004? All I could do is guess, and your guess is better than mine. I have to make mine in public and in print. That almost guarantees it to be wrong. I don't like to guess.

Will housing prices fall, and take the economy with it? I can make a very plausible argument that housing prices will remain stable. I gave you the argument above that they will drop. As regards to buying or selling a house, I would suggest taking the conservative approach. When any investment gets this far above long-term value trends, it is generally not a good idea to jump in, unless there is some fundamental shift in progress. While you can make a case for buying a stock above trend as a momentum investment, since you can buy or sell very quickly, homes cannot be traded quickly. When you buy today, you should be prepared to be in that home for a long time, or else be prepared to come to the table with cash when you sell.

My New Web Site

If you are an accredited investor and are interested in more specific investment advice about hedge funds and alternative investments, I suggest you go to my new web site, www.accreditedinvestor.ws and sign up for my free monthly letter on such private offerings. I also have a short list of recommended investment advisors, and will send you information on our services if you reply to this letter and request such. I will have a web site available on those services shortly.

Labor Day Fun

Chapters from my new book, Absolute Returns, will be posted on my web site next week. The important chapters on the case for a Secular Bear Market continuing for the rest of this decade are finished, and I PROMISE it will be out next week. I will give you the web address in the next letter. I will also be in New York on September 23-24, speaking at the IIR Fund of Hedge funds conference. I will have some time available to meet with clients and potential clients.

Labor Day at the Mauldin rented home means having lots of kids everywhere, and that is always fun. If you are thinking about going out, let me suggest seeing the movie, My Big Fat Greek Wedding, and taking the family. This summer sleeper is really worth your time, and will make you feel good when you walk out. My kids say it reminds them of our family.

Have a great weekend, and enjoy the fruits of your labor and the love of your family. Both are sweet rewards.

Your laboring under constant deadlines analyst,

John Mauldin

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