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Tuesday, March 31, 2009


house price declines still accelerating, continued again

returning to a theme -- calculated risk:

The Composite 10 is off 19.4% over the last year.

The Composite 20 is off 19.0% over the last year.

These are the worst year-over-year price declines for the Composite indices since the housing bubble burst started.

so far from a bottom, prices are still continuing to build momentum to the downside -- prices are falling faster now than ever. CR also notes that, though it is early returns, price declines are tracking the worse-case scenario once postulated by treasury for bank stress tests.

this was a case that looked a lot like consensus forecast when it was issued to me, and perhaps its even good news that house prices are no longer radically underperforming expectations. and one can at least imagine a slackening in the second derivative over the last few months. with inventories as a function of sales still near all-time highs but coming off peak in absolute levels, with new home starts having crashed almost completely, the seeds for an eventual base have at least been sown.

but i would also advise caution here. from richard koo's "the holy grail of macroeconomics" (2008), pp 152:

In 1996, the year before Hashimoto's fiscal reforms were launched, Japan recorded an economic growth rate of 4.4 percent, the highest among the G7 countries. Encouraged by this strong growth, asset strippers from New York rubbed shoulders with ethnic Chinese investors from Hong Kong in Tokyo hotels in late 1996 as they looked for real estate to buy. They came to Japan because land prices had fallen so fast that, relative to rents, properties had become attractive investments even by international standards. If the government had not scaled back its fiscal stimulus in 1997, the growth momentum from the previous year could have been maintained, and asset prices would likely have formed a bottom with the help of foreign investors.

Instead, fiscal consolidation torpedoed the economy, which proceeded to shrink for five consecutive quarters. This economic meltdown prevented foreign investors from carrying out due diligence, and drove them out of the country. (Due diligence involves verifying the profitability of a potential acquisition through careful estimates of future revenues and expenses. An economic collapse makes it impossible to forecast revenues, rendering due diligence, in turn, impossible.) Their departure, in turn, triggered a renewed slide in asset prices. Instead of stabilizing with the help of foreign investors in 1997, commercial real estate prices started falling again. From 1997 to 2003, commercial property prices plunged another 53 percent, further aggravating the balance-sheet problems of Japan's corporate sector.

This additional 53 percent drop in real estate prices was an unprecedented blow to the Japanese economy. Although property values in 1997 were down substantially from their peak, they were still no lower than in 1985, some six years before the bubble peaked. At that level, most Japanese companies could still absorb the losses and move forward, and for many firms, it was simply a case of paper profits disappearing or turning into small paper losses. But a further 53 percent decline from the levels of 1997 took real estate prices down to levels last seen in 1973. No company (aside from those that were debt-free) could escape serious balance-sheet damage in the wake of such a massive decline in values.

in other words, the first instances of significant positive carry on cash-flow-generating assets -- the precondition sought by paul mcculley as necessary to support house prices, though we remain far from it where i live -- were not enough to put in a bottom. john hempton has mentioned this phenomena in relation to japanese land during the bust as well, though perhaps without nailing down the explanation quite so clearly as koo, i think, has. with asset prices returning to valuations justified by discounted cash flow (DCF) analysis, further collapses of -- or temporary vacuums in the knowability of -- those cash flows can and will precipitate deep further corrections which serve to aggravate the nature of the depression and the imperative for balance sheet remediation. for the duration of a balance sheet recession, DCF will be highly dependent on fiscal stimulus emanating from the government.

if or when the dedication of elected officials -- who are as responsive to populist "common sense" concerns about government debt as they were oblivious to the actual creation of the massive private sector debt that was a necessary condition of this crisis and which the government must refinance onto its own balance sheet to prevent collapse -- to support economic activity by deficit spending equal to private sector debt repayments and savings falters, monetary aggregates and incomes and DCF and therefore especially levered asset prices will have room to fall much further than most anyone will now make mention of in the public record. such a failure of stamina, salutary examples of which accompany every debt deflation i am aware of, is almost certainly what sir john templeton had in mind when he famously forecast in 2003, well in advance of the hysteria and excess seen in 2005, 2006 and 2007:

Sir John also had a few words about debt -- a four-letter word that folks seem not to care about: "Emphasize in your magazine how big the debt is. . . . The total debt of America is now $31 trillion. That is three times the GNP of the U.S. That is unprecedented in a major nation. No nation has ever had such a big debt as America has, and it's bigger than it was at the peak of the stock market boom. Think of the dangers involved. Almost everyone has a home mortgage, and some are 89% of the value of the home (and yes, some are more). If home prices start down, there will be bankruptcies, and in bankruptcy, houses are sold at lower prices, pushing home prices down further." On that note, he has a word of advice: "After home prices go down to one-tenth of the highest price homeowners paid, then buy."

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Mankind's optimistic bias runs so deep... (though that is a good thing overall). I have yet to see anyone venture to put real worst case housing scenarios out there (at least in the context of avoiding a global financial meltdown). Other than your insufficient stimulus example, reasons why US housing may surprise to below the historical price/earnings or price/rent ratio (most have been mentioned but quite gingerly and not all combined, or quantified):

1. General tendency of overshoot to the downside
2. Significant excess inventory of houses built
3. Return to more occupants per household
4. Research shows that birthrates fall in hard times, so some of Japan's demographic birth rate problem is likely the RESULT of their crisis. There's no reason that couldn't start in the US and elsewhere.

I know some can be mitigated by policy (low rates for #1, government demolition plans for #2) but it's still an ominous mix.

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When there is blood on the streets, buy property.

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You bring up a lot of good points about the housing market, especially that now may be a good time to evaluate how to jump into it. As a contrarian and advocate of maximum pessimism, John Templeton would likely advise to invest against the crowd.

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