Current Valuations & Economic Implications


The paper at the bottom of this page has remained here since the time it was submitted in mid 2005. Currently (June 2008), many of the lax mortgage standards that where documented have know become common knowledge. The media now regularly reports on the ‘loose lending standards’ that lead to the current “mortgage meltdown” or “mortgage crisis”. However, I still do not believe the main-stream media has caught on to the price/rent or price/income aspect of housing valuations nor the constraining effects that these valuations are bound to have on future home prices.

Fundamentally, I assert that a simple index based on price/income could be used by the media for placing current housing-market valuations in a historical context; this could be beneficial in maintaining market stability. However, as I write this I am reminded of a quote by Warren Buffet, "I have seen no trend toward value investing ... There seems to be some perverse human characteristic that likes to make easy things difficult." Of course Buffet was writing mainly of stocks, but I argue this insight could be aplied to price/income methods used by economists in determining home valuations. Perhaps this provides some insight into why the main-stream media has not adopted a convention for evaluating home prices like they do for stocks (p.e. ratios), and why the main-stream media seems unwilling to place either one in any historical context.

The current state of the housing market raises two questions that I will be addressing through June 2008; in my view both issues remain unaddressed in any thoughtful manner by the main-stream media:
1) Is there a quick and easy method to stay informed regarding local housing market valuations?
2) What impact is the current state of housing likely to have on the overall economy?

Local housing valuations

I will start with local housing by recalling a study by economist Richard Dekaser. Dekaser continues to update U.S. housing valuations for ~300 metropolitan areas in the U.S. This study is:
• partially based on price/income ratios
• updated several times per year
• the most convenient method that I know of for estimating local valuations.
• represents a more thorough analysis than this staff of one could ever hope to compile.
• is free.
• unfortunately (for this research) factors current mortgage rates into "fair values".

For my research, I would prefer that Dekaser not base his analysis on current interest rates to determine each market’s fair value. This places a higher valuation on homes during years with low interest rates and lower valuations for years with high interest rates. In regard to placing current home valuations in a historical context, or estimating the potential for future price increases or decreases this makes Dekaser’s analysis less than ideal. However, it is an extremely methodical study of all major metropolitan areas and therefore deemed useful when viewed with the understanding that current interest rates effect Dekaser’s determination of fair value. In this context I view Dekaser’s work several times a year (keeping in mind the effect that current interest rates have on his analysis). A very intuitive overview of Dekaser’s study can be found by clicking here, with more details, including methodology, on the side.

Macrovestor remains focused on asset allocation, i.e., comparing returns on identical cash purchases. The site aspires to be a collection of tools for identifying under and over valued investments; money can be borrowed for any investment class that is determined to produce a greater rate of return than the loan’s rate. This is why I don’t consider interest rates when comparing investment classes side-by-side. Treasury yields (i.e interest rates) are simply another investment class. Treasury yields, loans, etc. from an investors stand point, can be compared to projected investment gains of stocks, real estate, etc.

In regard to a seperate interest-rate related issue, predicting the direction of interest rates for the purpose estimating the future value of an investment, I will once again quote Warren Buffet:
"Stop trying to predict the direction of the stock market, the economy, interest rates, or elections." (emphasis mine)
In regard to interest rates, this is a reoccurring theme with Buffet. Buffet believes that he is not capable of predicting future interest rates, and therefore he does not let them influence his investment decisions. In other words, he values an investment in the same way regardless of current interest rates. For the purpose of asset allocation and predicting future price investment gains (or decreases), I will stay with this convention of not factoring current interest rates.

Housing’s effect on GDP

In regard to the slow-down in housing and the effect on the overall economy, one of the most pertinent and credible papers that I am aware of is a paper done by/for the IMF. This is an elaborate study (click here for pdf) that looks at many “price bubbles”, in many economies, and in many different decades. The paper looks at the macroeconomic and financial aftereffects of the bursting of an asset price bubble. The study compares downturns in real estate to downturns in equities; one of the bottom-line determinations is that on average equity price bursts negatively affected the economy for 2-1/2 years while shaving 4% off of GDP. Housing price bursts have historically lasted almost twice as long with the negative effect on GDP twice as large. My thoughts on this topic are,,, well still being formulated; so I will end here before I misspeak (miswrite). I will be thinking and writing more on these topics through June 2008 with the aspiration of delivering an accurate but more concise view on the current state of housing.