Sunday, February 3, 2013

MARKET TRENDS: How a New Housing Bubble Could Develop

Robert Shiller doesn’t see one on the horizon

WE’RE beginning to hear noises that we’ve reached a major turning point in the housing market — and that, with interest rates so low, this is a rare opportunity to buy. But are such observations on target?
It would be comforting if they were. Yet the unfortunate truth is that the tea leaves don’t clearly suggest any particular path for prices, either up or down.
My ultimate takeaway is much different. The leaves I see are ripe for a new bubble and I’ll continue to try to draw out that case. What’s interesting here, however, is how little Dr. Shiller and I disagree on the facts.
Shiller goes on:

After screening out these effects, a number of indicators are up, including data for housingstarts and permits as well as the National Association of Home Builders/Wells Fargo Indexof traffic of prospective homebuyers, which has made a spectacular rebound since last spring.
What might explain this picture? It’s hard to pin down, because nothing drastically different occurred in the economy from March to September. Yes, there was economic improvement: the unemployment rate, for example, dropped to 7.8 percent from 8.2 percent. But that extended a trend in place since 2009. There was also a decline in foreclosure activity, but for the most part that is also a continuing trend, as reported by RealtyTrac.
 Shiller and I agree that nothing drastically different occurred in the the economy from March to September. What I do think happened is that the housing market passed a critical point – similar to the notion of “tipping points”, popularized by Malcom Galdwell. 
Prior to the Winter of 2011/2012, weakness in the housing market was creating conditions which fostered further weakness in the housing market. During that winter we crossed a point where conditions in the housing market were fostering increased strength in the housing market.
The housing market and the larger economy were still subject external shocks including the debt ceiling debate, the European Crisis and unexpectedly strong austerity by State and Local governments.
However, the underlying conditions were still building on themselves.
Importantly, I tend to think of these conditions as being driven by financial interactions
while Dr. Shiller thinks of them as psychological.

And, last spring, along with Karl Case of Wellesley College and Anne Thompson of McGraw-Hill Construction, I conducted a detailed survey of the attitudes of recent home buyers in four American cities, as I discussed here in OctoberWe did not see any evidence of increased optimism.
In short, it is hard to find an exact cause for the rebound in home prices.
Shiller points to optimism because he is thinking in terms of an “Animal Spirits” type model, where for largely unidentifiable reasons a general attitude of optimism builds and this propels prices higher.
In contrast, I think of liquidity interactions and positive feedback. The more willing your neighbor is to buy a house the more willing you should be as well.
Well, because one of the major downsides of buying a house is that your equity is locked up in it and you have this very long term mortgage contract that its hard to get out of.
However, if someone is willing to buy the house from you then this offers you away to both extract your equity and get out of the mortgage contract. Thus, your neighbors’ willingness to buy a house lowers the cost to you of buying the house.
So, since the cost is lower you are more willing to buy the house. And, now that you are more willing to buy the house, this should make your neighbor even more willing to buy the house, since you lower his costs of making the purchase. This process builds on itself until everyone really wants to buy the house.
On a basic level this phenomenon is not strange to financial economists. Its called a liquidity premium and its variance over time drives both difference in volatility and average return between investment vehicles.
What’s unusual is the enormous and relatively rare shifts in liquidity premium associated with an asset like “US Housing.” This type of thing is atypical in developed markets with steady nominal growth.
The dynamics are more akin to international hot money flows that can overwhelm the shallow capital markets of developing economies. However, with nominal growth slowing, the global population aging and developed economy governments reluctant to issue large amounts of debt this dynamic will affect larger and more traditionally stable asset markets.

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