IS HOUSING DUE TO REVERT TO THE MEAN PRICE?
I’ve long predicted that housing prices would revert to their mean. The popular chart that depicts this long-term mean is the Case Shiller inflation adjusted housing chart (see Figure 1 or 2 below). The logic here is not terribly complex. In addition to the supply/demand imbalance housing prices must revert to their mean for the simple reason that prices tend to have a very high correlation with inflation rates. Inflation rates, by definition, tend to have a very high correlation with wages. Since house purchases comprise such a substantial amount of the household balance sheet it makes sense for this correlation to remain very tight over any given period of time. It is practically impossible for housing prices to revert from their inflation adjusted mean for any significant period of time. This is taking a complex argument and simplifying it far too much, but Gary Shilling recently expanded on this mean mean reversion that is likely to continue in housing (via Business Insider):
“This huge and growing surplus inventory of houses will probably depress prices considerably from here, perhaps another 20% over the next several years. That would bring the total decline from the first quarter 2006 peak to 42%.This may sound like a lot, but it would return single-family house prices, corrected for general inflation and also for the tendency of houses to increase in size over time, back to the flat trend that has held since 1890 ( Chart 26).We are strong believers in reversions to the mean, especially when it has held for over a century and through so many huge changes in the economy in those years—two world wars and the 1930s Depression, the leap in government regulation and involvement in the economy, the economic transformation from an agricultural base to manufacturing and then to services, the post- World War II population shift from cities to suburbs, the western and southern transfer of population and economic strength, the movement from renting to homeownership and the accompanying spreading of mortgage financing, etc.
Furthermore, our forecast of another 20% fall in house prices may be conservative. Prices may well end up back on their long- term trendline (Chart 26), but fall below in the meanwhile. Just as they way overshot the trend on the way up, they may do so on the way down, as is often the case in cycles. Furthermore, another big house price decline will spike delinquencies and foreclosures leading to more REO sales by lenders,whichwillfurtherdepress prices. Our analysis indicates that a further 20% drop in prices will push the number of homeowners who are under water from 23% to 40%, resulting in more strategic defaults, more REO, etc.”
(Figure 1)
This month’s Dallas Fed Economic Letter also discussed the phenomenon of mean reversion in housing:
“As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85 percent to their highest level in August 2006. They have since declined 33 percent, falling short of most predictions for a cumulative correction of at least 40 percent.[1] In fact, home prices still must fall 23 percent if they are to revert to their long-term mean (Chart 1). The Federal Reserve’s purchases of Fannie Mae and Freddie Mac government-sponsored-entity bonds, which eased mortgage rates, supported home prices. Other measures included mortgage modification plans, which deferred foreclosures, and tax credits, which boosted entry-level home sales.”
(Figure 2)
The government has thrown everything it has at the housing price decline. But as the housing tax credit recently proved there is little the government can do to stop this inevitable and entirely necessary market adjustment. The Dallas Fed expanded on the difficulties that the housing market confronts:
“Measuring the success of these efforts is important to determining the trajectory of the economic recovery and providing policymakers with a blueprint for future action. New-home sales data, though extremely volatile, are considered a leading indicator for the overall housing market. Since expiration of the home-purchase tax credit in April, sales have fallen 40 percent to an average seasonally adjusted, annualized rate of 283,000 units. This contrasts with the three years through mid-2006 when monthly sales averaged 1.2 million on an annual basis. Before the housing boom and bust, single-family home sales ran at half that pace. Because current sales are at one-fifth of the 2005 peak, new-home inventories—now at a 42-year low—still represent an 8.6-month supply. An inventory of five to six months suggests a balanced market; home prices tend to decline until that level is achieved.
One factor inhibiting the new-home market is a growing supply of existing units. The 3.9 million homes listed in October represent a 10.5-month supply. One in five mortgage holders owes more than the home is worth, an impediment that could hinder refinancings in the next year, when a fresh wave of adjustable-rate mortgages is due to reset. The number of listed homes, in other words, is at risk of growing further. This so-called shadow inventory incorporates mortgages at high risk of default; adding these to the total implies at least a two-year supply.[2]
The mortgage-servicing industry has struggled with understaffing and burgeoning case volumes. The average number of days past due for loans in the foreclosure process equates to almost 16 months, up 64 percent from the peak of the housing boom. One in six delinquent homeowners who haven’t made a payment in two years is still not in foreclosure.[3] Mounting bottlenecks suggest the shadow inventory will grow in the near term.
Notably, not all homeowners in arrears suffer financial hardship due to unaffordable house payments. Those with significant negative equity in their homes may choose to default even though they can afford to make the payments. Such “strategic default” is inherently difficult to measure; one study found 36 percent of mortgage defaults are strategic.[4] Though the effect is not readily quantifiable, the growing lag between delinquency and foreclosure provides an added inducement for this form of default.”
The government has won the battle, but ultimately, they are destined to lose this war with the market. They have attempted to keep “asset prices higher than they otherwise would be”, however, the laws of supply and demand always reinforce themselves over the long-term. By propping up markets the government has merely kicked the can. The mean reversion will occur one way or another. The government appears to be attempting to ease the markets lower. That is arguably more desirable than crashing prices, but does not mean they will ultimately win the war. Mean reversion will occur. It’s only a matter of how long we want to drag it out….
Good post. I continue to wonder how much as a percent of disposable income will go towards health care, utilities, and other necessities in the future and how that plays out in the housing market.
As you said above, inflation closely tracks wages. How that plays out will ultimately play a huge roll in real estate going forward. I just don’t know how the bottom 80% of earners will be able to soak up $4 gas, rising food prices, and the continued health care increases that happen. Won’t that be a drag on housing prices going forward as people have much less income to allocate towards housing?
Great article. Another risk factor is the potential elimination of the Mortgage Interest Deduction which has been in the US Tax Code since 1913. In 1913 the tax excluded the first $4,000 of income for married couples; less than 1 percent of the population earned more than that back then. As we know, today it’s is a much bigger factor in home ownership economics.
The Mortgage Interest Deduction is not the “sacred cow” many believe it is. Recall that the Tax Reform Act of 1986 (TRA86) eliminated the deductible interest on all personal loans (including credit card debt)…a controversial change at the time. Also, I suspect many in Congress could fold under the pressure of record deficits if the idea is pushed.
The point is there has been serious consideration inside the beltway to eliminate the Mortgage Interest Deduction. So, ask your self what happens to the mean if that occurs? Does it drop? Does the slope change? I think the answer to these questions is yes. Is this a serious risk to consider from an investment point of view? I think the answer to that question is also yes.
Maybe if the defecit begins to seriously threaten Federal government solvency, particularly with rising interest rates, Congress will do “unthinkable” things, such as cutting entitlements and eliminating “sacred cow” deductions. The Money Power allows Congress to be in defecit year after year, but if interest rates start rising rapidly, Congress will have to do something just to avoid an unsustainable interest bill. They won’t have to eliminate the deficit (they can’t), but they would have to convince the money markets that they are sane and responsible to bring down interest rates. It is either that or allow the Fed to buy up all Treasury debt – a course that ultimately leads to complete loss of confidence in the US currency and hyperinflation. A more austere budget is a much better option than a complete loss in confidence.
During the early to mid 2000s, many observers believed a ‘global’ property bubble was developing, as many individual countries around the world were experiencing prolonged property booms that were beginning to display worrying bubble-like symptoms. Some observers believed this global house price bubble would necessarily be followed by a global house price crash (GHPC).
A reversion to the mean is not that big a drop from where we are now, given how much prices have declined from the peak. And it would probably be a good thing in that it would give buyers and sellers more certainty as to what the property was really worth. Mean reversion would force the banks to finally unload their REO properties.
There is no evidence in the above graphs that house price changes overshoot like stocks when correcting from a big move. However, if the banks hold out too long and then unload all their foreclosed and delinquent properties at once, prices could easily overshoot on the downside. There are also a lot of things about the current environment that are truly unprecedented. For instance, central bank short term interest rates are at a 500 year low.
The financial markets which are closely bound to the housing market through mortgages are working much more in correlation with investor expectations than with the real supply and demand in the housing market. The problem is maybe that investors want to have certain expectations which bring them higher yields. And the recent, present or future homeowner is constantly lied to. I definitely agree that the government tax credit is just tilting at windmills. The sooner we get to the mean and maybe start a very slow rise, the better for the market.