With the stock market stagnant due to heightened geopolitical risk and potentially even a bit of a hangover from the tech bubble we just experienced (or are experiencing), I thought it would be useful to try and look behind the hype and see what the data is actually telling us.
First of all, let’s take stock of the current analysis and popular narrative developing in news organizations and social media which influences much of our own thoughts and opinions on markets in general, especially of one so closely linked to our personal situation like the housing market.
For some time now I have been a vocal critic of media and especially the financial press. Sensationalism is baked into just about every story you see. It pays to be skeptical. Journalists and editors have noticed the human tendency to focus on the worst news and the most dire information which leads to more clicks and more eyes drawn towards particular stories. The phrase “if it bleeds it leads” comes to mind. In the financial press this is evidenced in fear based headlines: Markets are In a Bubble, Such and Such says a Crash is Imminent or based on fear of missing out (FOMO): Hedge Fund Sees Windfall on Commodity Bet.
Besides the fear based analysis I have another issue with journalistic interpretation of markets: they tend to have a backward looking bias. What I mean by this is that there is a tendency to look at the current market situation and assume that it may play out like a drop or crisis in the recent past. In the case of the housing market today, we have a situation where journalists and commentators are comparing the current run up in prices to the housing crash which the US experienced in 2007-2009.
This is a problem not only for how we look at the housing market but also for policy makers in general. Post crisis policy initiatives like the Dodd-Frank act or stringent stress testing on banks generally tend to take the approach of trying to prevent a crisis that has already happened while often missing the seeds of the next recession entirely. I personally think the Fed has been enthralled towards this backwards looking bias in their recent interest rate policy. Years of outsourcing and cheap imports from Asia and the emerging world which have shipped jobs overseas for the benefit of lower prices that have helped underpin lower inflation in the U.S. for the past 30 years. The public and likely the Fed itself, grew complacent in this environment. The Fed was able to bring rates lower at any sign of recession without having to deal with the fallout of higher inflation as a result. I think this also influenced who politicians thought could run the Fed as well. Out were the academically inclined Fed Governors like Alan Greenspan and Janet Yellen and in came Jerome Powell, a lawyer and former banker with little to no training on monetary policy.
Powell and the rest of the Fed governors seem to have assumed that the pandemic and the supply chain disruptions it produced could be remedied by a reaction very similar to that taken during the financIal crisis with massive quantitative easing and rock bottom rates for extended periods underpinning the recovery. Yet the pandemic was no typical recession and it wasn’t the housing crisis induced recession of 2007-2009. The bounce back has produced not only buoyant markets in 2021 but some of the highest inflation the US has seen in almost 40 years.
The Fed took a lot of heat for missing the last housing bubble and now they are under pressure not only to show they are monitoring the current one closely but also attacking inflation. It’s one reason that the Dallas Fed has created an analysis team to cover just the housing market which also coordinates with an international team of academics looking at house prices in a number of developed and emerging markets. The data they present tells us something but I don’t think it is as decisive as many are making it seem at the moment.
Back to Housing
With that said, let’s get back to the housing market and particularly the data presented by the Dallas Fed in a report published on March 29. The study basically looks at 3 simple fundamental factors which are generally relevant for any analyst that looks at a housing market nationally or locally:
1. How fast the growth in prices has been in the past few years compared to the historical average.
2. The price to rent ratio, which tend to rise if prices are rising faster than rents, signaling that prices are growing faster than what the market can handle.
3. The price to income ratio. If this is out of line for an extended period it’s usually a strong indicator that housing is indeed in a bubble.
Below I’m going to share the same graphics that the Dallas Fed shared in their report. What’s important to note on all of these is that the shaded areas represent periods of time when these statistics produced figures higher than 95% of all the historical average data. 95% is a kind of statistical rule of thumb which shows that the numbers are an extreme outlier, lending further credibility to the argument we may be headed towards a bubble.
The first thing we notice is that prices can climb at a fast rate for a pretty long period of time. The data on chart 1 indicates that it was looking bubbly during the last housing bubble for almost 10 years from 2000 to 2008. I wouldn’t put a lot of stock in this indicator given that it could take a long time to be proven useful.
The second chart shows price to rents elevated for a period of around 6-7 years from 2000-2007. Only recently have they climbed above the 95% figure so again it doesn’t seem this can be a good short term predictor. Unfortunately it also means that prices could remain on a run for an even longer extended period of time.
Chart 3 actually goes against the popular narrative and tells us that yes, prices are climbing but are not flashing red and may even have more room to go up.
What Else This Tells Us
None of this takes into account recessions, inflation or interest rates, which all have an effect on all of these figures.
Rates have climbed almost 2 percentage points in the past 6 months which makes the mortgage payment on a $600,000 home almost $1,000 more expensive per month. This further raises the barrier to entry before prices are able to climb higher. It doesn’t necessarily mean prices will not climb further but with more rate rises very likely on the way, it’s a precursor to a strong break that could be coming for the housing market within the next year.
The other factor which has been less discussed is that home builders are attempting to meet the demand. At the moment 1.6 million homes are under construction in the US. As seen via the census data below, this is still not large compared to historical figures but what is interesting is that multifamily home construction is at a 30 year high.
Home construction in general is still below the 4 million home shortage that many analysts think the country faces but represents 40% of the gap about to hit the market in the next year or so. It’s not a stretch to think that even with the materials shortage many of the builders are seeing, that an influx of homes in the next couple of years would ease supply in a very tight market.
The final factor that is a poor presage for further dramatic price rises is the effect that the swift rate rises will have on the economy. Although the job market and the economy seem to be humming along at full capacity at the moment, high inflation and higher rates threaten to derail not only consumer sentiment but also the jobs picture. If the result of killing off inflation through aggressive rate increases this year is a recession next year, this also will not bode well for home prices given how dependent they are on the consumer. The big bank results we saw from names like Wells Fargo and others last week showed that many of the banks themselves are gearing up for a slower economy by stashing reserves in anticipation.
With that being said, short term rate rises won’t correlate 100% to increases in mortgage rates if they rise 0.25%-0.50% in the next few months. If rates rise by 2%-3% over the next year or so though, and push mortgage rates well above 6% or 7%, this could start to finally push back on demand in the housing market and this is the parallel with 2006-2007 where mortgage rates hit levels between 6%-7% in early 2007.
What We Can Expect
Home prices are seasonal and I do expect homes to increase in value this summer given continued construction shortages but with all the headwinds facing housing as well as the economy, I am not as confident in this strong price momentum to carry into summer 2023. On a personal basis I am holding off on purchases for the time being and making sure I have enough liquidity to cover a downturn as well as any of life’s emergencies. This can enable one to not be plunged into crisis mode if a job situation changes or to potentially take advantage of a soft market if it does eventually come around.
Based on actually looking at the Fed’s data it does seem a bubble could be just starting to develop but at the same time a lot of the headwinds it faces may choke off the bubble before it becomes a problem the size of the one seen in 2007-2009. This may be welcome news for millennial and Gen-Z buyers.
In the next year however, I wouldn’t expect a lot of relief in the single family home market, it seems higher prices may continue to be the story for much of 2022.
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