A pullback in the housing rally, or the peak of another housing bubble?
The housing rally of 2013 is over. We are past the peak selling season, and although the year-over-year numbers will still show gains, we are entering the time of the year when seasonal factors drag prices and sales volumes down. If we were in a normal market, we would see price declines over the next 4 to 6 months. However, these are not ordinary times.
The big question right now is whether or not the combination of higher interest rates and seasonal factors will cause a brief pullback in the housing rally, or if we just witnessed the peak of another housing bubble. Mark Hanson among others makes a strong case that we just witnessed the end of the rally and the beginning of another long, painful decline.
Published: Tuesday, 10 Sep 2013 | 6:00 AM ET
By: John Carney | Senior Editor, CNBC.com
A recent paper by three economists from Robert Morris University in Pennsylvania, however, suggests that the index can be used to detect housing bubbles. Adora Holstein, Brian O’Roark, and Min Lu track the index against its long-term trend line. When the index falls below trend, it marks a possible start of a housing bubble. They suggest that when the monthly affordability index value falls below trend for at least three months, a housing bubble probably exists.
Using the monthly composite home affordability index from FRED, the database maintained by the St. Louis Federal Reserve bank, we can chart out every single monthly index report and construct a long-term trend line.
The problem with this analysis is fairly obvious; the construction of their long-term trendline is arbitrary curve fitting. I’ve seen this many time with stock price indicators. Someone takes their moving-average crossover or some other indicator and tweaks the parameters until it perfectly predicts when they should have entered and exited trades in the past. The problem is the past rarely repeats itself in a ways that match optimized indicators. Similarly, the above trendline these economists constructed looks great on paper, but it will fail to capture the key inflection points in the future.
Further, the base data they are using isn’t accurate price data, it’s an equally arbitrary and oft-manipulated data series put out by the NAr. The fact is the NAr affordability index is completely worthless. Anything built on this worthless garbage will be equally worthless.
As the Robert Morris economists found, affordability fell below its long-term trend in the beginning of 2004—marking the beginning of the housing bubble. Homes remained below the long-term trend for affordability until December 2008.
This year affordability fell below the long-term trend in April. We remained below trend in the May, June and July reports.
If the Robert Morris economists are right about below trend affordability indicating a housing bubble, we’re definitely there right now.
This does not mean that home prices are poised crash immediately. Keep in mind that home prices continued to climb for over two years after affordability fell below trend, peaking in April 2006.
The problem with any bubble indicator is getting the timing right. I believed we were in a housing bubble in 2004, and I fully expected it to burst then. It never occurred to me lenders would completely lose their minds and start peddling negative-amortization loans. This added two years to the housing rally that never should have happened.
But it may mean that the Federal Reserve might need to start raising interest rates sooner than some expect in order to deflate our new housing bubble.
The federal reserve has already made it clear they don’t believe strongly enough in their own ability to spot a financial bubble to take measures to deflate one. If this is a method they are considering, they will fail to get it right.
These authors are not the only ones who believe we are in a housing bubble. Mark Hanson is convinced we are on the cusp of a major decline.
The following is my opinion based on my research. I could be completely wrong; I often am. But I am right more than I am wrong. And it’s a lot easier predicting the end of this ‘movie’ when you have already seen the previous two installments of this series in the past 6-years. The next few months will bring out the truth abut the “post-surge” housing market.
Last month, after the “shocking” 27.4% July MoM drop in headline unrevised New Home Sales — reported down a rosy 17% NSA (-13% SAR) after the record 10.4% June downward revision was swept under the rug —
Those are crushing declines in sales. Notice it was hardly mentioned in the mainstream media, and nobody pointed out the massive downward revision (I missed that one too).
that followed by “2-days” a multi-year high “July” Existing Home Sales, the market is thirsting for more, “post-surge” housing data. Especially, given how much the leading indicating builder stocks have sold off on the rate “surge” and how little everything else related to housing has on a relative basis.
Homebuilding stocks are a good leading indicator. They rallied just before the housing market bottomed, and they sold off just as interest rates started to rise. If you believe in the rally, this is a great time to buy homebuilding stocks.
The market remains polarized on the topic. Some think the rate “surge” will have little impact; others are betting the surge had a “calming”, or “normalizing” effect; while the bears — clearly a minority at this stage (perhaps just me at this point!) — think the rate surge was a rare and powerful “catalyst” only rivaled two times in the last seven years. The first, when the housing market lost all it’s high-leverage loan programs all at once in 2007/2008; and the second, on the sunset of the Homebuyer Tax Credit in 2010.
Mark’s analysis is good. The parallels are worth noting. Perhaps the housing bears are right, but prices will go up anyway.
In both these previous instances — over a long period of time — leverage-in-finance/stimulus created a ton of incremental demand and pulled-forward as much, or more. Then, when the leverage/stimulus went away — over a very short period of time — housing “reset” to the current supply/demand/lending guideline/interest rate environment, which in 2008 resulted in the “great housing crash”, and in 2010 the “double-dip”.
That is exactly what happened then, and it just repeated when rates surged. When the tax credit stimulus was removed, house prices dropped for 18 consecutive months. The decline was not as serious as the deflation of the main bubble, but it was noteworthy and frustrating for everyone who wanted to see prices go up.
Here we sit in a eerily similar situation. From Q4 2011 through May 2013 housing was injected with arguably the greatest stimulus of all time; a 2% “permanent mortgage rate buy down” gift from the Fed.
That’s an interesting way to look at the stimulus. It was like an interest rate buy down that builders use to get through tough times and keep prices up.
Over a very short period of time in 2011 the plunge in rates from the 5%’s to the low-to-mid 3%’s created 15% to 20% instant “affordability”, or “purchasing power”, out of thin air. In other words, a buyer on a flat income could instantly pay 15% to 20% more for the same house; or put another way, they could buy a house that cost 15% to 20% more…ca-ching! Over a few short quarters, housing prices “reset” higher to this new found purchasing power.
This stimulus only worked because the banks simultaneously removed all the supply. That is one big difference between the current conditions and those in 2010. IMO, that’s why we won’t see 18 months of falling prices this time around.
By this time, everybody was so used to the Fed stepping on rates for so long they completely forgot that all this new found interest in houses was happening in the context of the greatest stimulus of all time, and starting chanting “escape velocity” and “durable recovery”. If it all would have stopped there we would “not” be sitting atop another housing bubble right now…that just popped. Rather, we would be sitting on a hill ready for a “retracement” of “some” of the past 18 months of gains…no harm, no foul.
In summary, the past two-years of massive Fed, Gov’t, and bank intrusion into the housing market went way too far. Houses are mis-allocated, there is no shortage of houses “in which to live”, and in ALL the popular “mega-recovery” regions are at least 50% expensive on a monthly payment basis than they were at the peak of the housing bubble in 2006.
This is where I strongly disagree with Mark based on the data I look at. We are nowhere near the same cost of ownership as we were in 2006. We certainly aren’t 50% higher.
And all it will take is the wave of “cash-money” buyers ‘easing off” a bit; “some” of the organic first-time and repeat buyer cohort stepping away due to the sudden lack of “affordability”; and/or a wave of supply from “panic sellers” hitting the market to send sales volume and prices down sharply, over a very short period of time. And I think the rate “surge” catalyst has caused all three to occur at the same time.
I also can’t buy the argument of panic selling or any substantial amount of must-sell inventory coming to the market. Without significant must-sell supply, prices won’t go down. I believe we will continue the Mexican standoff in the housing market.
I don’t believe we’re in a bubble… yet
Since I first came to believe California house prices were in a bubble in 2003, I’ve worked to refine the analysis and methodology I used to spot the housing bubble. My method is to compare the cost of ownership to the cost of a comparable rental. These two variables are related because people can obtain the use of housing through either method. People chose the method that minimizes their costs or maximizes their perceived benefits.
The ratio between the cost of ownership and rent is consistent during periods of price stability. If the ratio is at “1”, the market is at rental parity. More desirable markets carry a premium for ownership, and less desirable markets sport a discount. When current pricing deviates from these norms, the market is either overvalued or undervalued.
Below is a recent chart comparing rental parity to the median home prices for Orange County. Notice that the two lines meet at today’s pricing. Orange County is neither overvalued or undervalued based on the historic relationship established between 1993 and 1999. Based on this analysis, the housing bubble of the late 1980s and the recent housing bubble of 2003-2009 are obvious.
The false rally of 2010 was more difficult to spot. The price relationship between rental parity and the median resale price suggests that the 2010 rally would not fizzle out due to problems with affordability. However, the conditions in 2010 were so unfavorable that the rally could not endure. The fake rally created by tax credits masked the underlying problems with tightening credit, a depleted buyer pool, severe downward price momentum, and an excess of must-sell inventory. It was only the removal of the must-sell inventory and continued interest rate stimulus that caused the market to bottom in 2012.
The main reason I don’t believe the current move is a bubble is because it doesn’t fit the traditional definition. The asset class is not overvalued. In fact, most markets still show housing as undervalued, some severely so. Given how low the cost of ownership is relative to rents in places like Riverside County, I don’t see prices crashing further from here. In short, we aren’t in another housing bubble.
It may turn out that I am wrong. If the market does crash, it will be because rising mortgage interest rates cause affordability to plummet, and the currently undervalued conditions will reverse. That’s a scenario that could come to pass, but for right now, markets are not overvalued, and because of that, I can’t get behind the idea that we’re in another housing bubble.
[idx-listing mlsnumber=”OC13178510″ showpricehistory=”true”]
27816 VIOLET #143 Mission Viejo, CA 92691
$449,900 …….. Asking Price
$149,000 ………. Purchase Price
5/3/2000 ………. Purchase Date
$300,900 ………. Gross Gain (Loss)
($35,992) ………… Commissions and Costs at 8%
$264,908 ………. Net Gain (Loss)
201.9% ………. Gross Percent Change
177.8% ………. Net Percent Change
8.3% ………… Annual Appreciation
Cost of Home Ownership
$449,900 …….. Asking Price
$15,747 ………… 3.5% Down FHA Financing
4.67% …………. Mortgage Interest Rate
30 ……………… Number of Years
$434,154 …….. Mortgage
$135,675 ………. Income Requirement
$2,244 ………… Monthly Mortgage Payment
$390 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$94 ………… Homeowners Insurance at 0.25%
$488 ………… Private Mortgage Insurance
$289 ………… Homeowners Association Fees
$3,505 ………. Monthly Cash Outlays
($567) ………. Tax Savings
($554) ………. Principal Amortization
$28 ………….. Opportunity Cost of Down Payment
$76 ………….. Maintenance and Replacement Reserves
$2,488 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,999 ………… Furnishing and Move-In Costs at 1% + $1,500
$5,999 ………… Closing Costs at 1% + $1,500
$4,342 ………… Interest Points at 1%
$15,747 ………… Down Payment
$32,086 ………. Total Cash Costs
$38,100 ………. Emergency Cash Reserves
$70,186 ………. Total Savings Needed