Wednesday, October 31, 2007

S&P/Case-Shiller

The latest data from the S&P/Case-Shiller home price index were released yesterday, showing continuing weakness. I have produced a chart from the data, both the index (red line) and the annual percent change (blue line). Click to enlarge.

Data: S&P

From January 2000 to August 2007 (latest data) the total rise in home prices was 114%, i.e. house prices more than doubled on average. In the same time, CPI inflation rose a total of 22.3%. In the next chart we can see how much faster real estate prices (blue line) rose in the US versus inflation (purple line). Obviously this sort of real estate overpricing cannot persist, but the relevant question is: how will the balance be restored?

The mildest scenario is that real estate prices will gradually ease and then flatten out for a long time, giving inflation a chance to catch up. Given what we already know about mortgage defaults and MBS prices, this is highly unlikely. After the ongoing decline in housing transaction volumes (existing home sales and new construction) the next step will be significant price declines; as we know, in markets price follows volume. A hint came from Mr. Mishkin's paper mentioning a possible 20% decline in house prices, even if this came in the context of a monetary policy model.

Another scenario is to engineer a much faster increase in inflation but, as the chart makes clear, this is impossible given the size of the re-adjustment necessary. Anything that even approaches this rate of inflation acceleration would destroy the US economy and the value of the dollar.

So, what is likely to happen? In my opinion, prices will initially break from a combination of bank auctions, builder inventory clearances and speculators rushing to the exit doors. We have hints of the size of this initial price drop from isolated auctions already taking place: as much as 30% off from peak prices. I think that banks will soon feel ecstatic if they can recoup 75% of their loan principal and will increasingly pressure the market downward, in a rush to be first out of the door. (This is what the various ABX indexes are already telling us, by the way.) The second chart also shows that the pressure will not be contained to houses bought in the peak years of 2005-06, because the massive price imbalance vs. inflation started in 2000 - in effect, it is possible that even people who bought houses as far back as 2002 will be negatively affected, particularly in the areas that spiked up the most in price (CA, FL, NV, etc).

Thus, I see a 20-30% initial "break" and then a long period of price under-performance, perhaps lasting as much as a decade that will restore house prices to levels reflecting their utility as homes, rather than trading sardines.

16 comments:

  1. Hellasious,

    What do you think of the validity of the inflation data supplied by BLS? I believe the many changes to their methodology over the years (substitution, weighting hedonics, etc.) have caused “official” inflation to be understated relative to “actual” inflation. My monthly living costs surely have gone up more than the CPI data indicates. Mr. Williams at Shadow Government Statistics maintains a data series of the different outcomes.

    http://www.shadowstats.com/cgi-bin/sgs

    Enjoy reading your work. Have a nice day.

    ReplyDelete
  2. By the way, CR also has a good discussion on the behavior of housing prices.

    ReplyDelete
  3. Hellasious,

    Nice touch with reintroducing the sardine analogy. Yes, that has been a major money making trick - take a basic item and with various mechanisms inflate it again and again.

    Tim

    ReplyDelete
  4. I enjoyed reading this post, thank you.

    ReplyDelete
  5. What is up with Q3 GDP? It is very high?
    Something does not make sense.

    ReplyDelete
  6. I live in a neighborhood with high home prices and as yet there hasn't been the kind of across the board collapse (or really any sort of collapse in home prices). One wonders if and when the upscale neighborhoods will see the price stickiness come unstuck, so to speak.

    ReplyDelete
  7. I just love this blog. Complex isses distilled down to their bare essence so that anyone can understand them. I started reading SuddenDebt a few months ago, and then got so interested I read it from start to finish. An education in itself.

    Hellasious, I am finally bold enough to ask what may well be an unanswerable a question. When does the Fed cut its losses on trying to save the economy and start saving the USD? Will they have the will to do it when required? It seems to me Bernanke's actions and comments indicate that saving the USD is rather low on his list of priorities. Economy first second and third. USD last. By the time he decides to save it, it may well be too late and will have ridden it into the ground.

    ReplyDelete
  8. Firstly, thank you all for your kind comments - they are greatly appreciated.

    On 3Q GDP, see the next post.

    On the value of the dollar: it is the viewpoint of the Fed that this is the obligation of the Treasury department.

    Regards

    ReplyDelete
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