Making the Case That No Housing Bubble Exists

By Dr. Duru written for One-Twenty

April 19, 2006

It happened again. Yesterday, I was going to sound the alarm bell that the first cracks in the housing stock bottom thesis were starting to show. I did not write the piece and once again the market rewarded my procrastination with a powerful rally in homebuilder stocks. And not only that, a buddy of mine sends me the summary of an article that claims that only ONE metro area in the entire United States is experiencing a housing bubble. The full article (in PDF format), "Bubble, Bubble, Where's the Housing Bubble?" paints a very promising tone about the housing market. The main argument is that if you look over the long-term, the prices paid today are actually mainly just right or far below fair value. Now, imagine my disbelief given my indoctrination in bubbology! My main reaction is that this sounds eerily similar to the arguments that justified a 100 P/E on Cisco right before the tech bubble crash. That is, if you look at cash flows far enough into the future, you can justify paying almost any price now! Anyway, here is the abstract for you folks who can't be bothered going to the link and reading for yourself:

"Housing-bubble discussions generally rely on indirect barometers such as rapidly increasing prices, unrealistic expectations of future price increases, and rising ratios of housing price indexes to household income indexes. These indirect measures cannot answer the key question of whether housing prices are justified by the anticipated cash flow. We show how to estimate the fundamental value of a house and use unique rent and price data for matched single-family homes in ten metropolitan areas to illustrate this approach. These data indicate that the current housing bubble is not, in fact, a bubble in most of these cities in that, under a variety of plausible assumptions, buying a house at current market prices still appears to be an attractive long-term investment. Our results also demonstrate the flaw in models that gauge bubbles by comparing movements in housing price indexes to movements in other indexes or to values predicted by regression models."
Abstract from "Bubble, Bubble, Where's the Housing Bubble?" by Margaret Hwang Smith and Gary Smith.

In addition they claim that of ten metro areas only ONE is actual stuck in a bubble: San Mateo county. This was the exact county I lived in before coming to Atlanta which is supposedly 53% under-valued. So I guess my main issue before is that I was surrounded by the most profligate spenders in the nation! Hmmmm....
Anyway, back to the still developing bottom in housing stocks. I was ready to declare victory after TOL had steadily risen for two months and KBH led a brief rally after its last earnings report. But as interest rates have steadily risen, these rates have taken their toll on the housing stock bottom thesis. Early Tuesday, I noted CTX was about to scrape its 52-week lows and re-test support at the October low. HOV has already broken through it's 52-week lows...although it had done the same a month before as well. I always thought that MTH would get the worst treatment. In fact, it was just two months ago that MTH looked in trouble and CTX looked just fine!
Finally, what about the huge rally on Tuesday that pretty much "saved" housing stocks for now? Well, oil kept going up, and everyone seemed so pleased by the inflationary prospects that they bought stocks hand over fist. OK...that does not make sense. The standard explanation for the day is that a report on wholesale inflation showed no sharp teeth, and San Francisco Fed President Janet Yellen worried aloud that short-term rates could get too high. By this time, folks began to speculate again that the Fed would have to stop the rate-hike campaign soon... or else the economy would be ruined. And the Fed does not want that, right?! Sure enough, the minutes of March's Fed meeting came out in the afternoon, and speculators were rewarded by what appeared to be dovish comments from the new Fed. At last, the whites of the Fed's eyes are starting to reveal themselves! Well, you faithful readers know that I simply cannot accept the packaging from the mainstream press - I need to read things for myself...
  1. First, nothing changed about the statement that was issued back in March. Still no new news there.
  2. The Fed must be pretty satisfied with itself. It pulled off something which was supposed to be impossible: both slow down the housing market without popping it and without damaging the rest of the economy. Referring to the economy's prospects later this year, Fed participants note that "the ongoing cooling in the housing market would act to restrain residential construction and growth in consumption, but business and household confidence and supportive financial conditions would help to foster growth in employment and incomes, keeping consumption and investment on a solid upward track." And just to have it both ways, we read the following claim: "Going forward, participants expected a deceleration in house prices to contribute to an increase in the household saving rate and to weigh on consumption growth." Apparently, if it weren't for softening real estate markets, the economy would be ripping! Say, like an India or China even?!
  3. The Fed seems ambivalent in its overall assessment of the inflation dangers. They seem to believe that macro conditions have successfully conspired to cap pricing pressures, yet they cast a wary eye toward escalting energy costs: "...productivity growth, moderate increases in compensation, contained inflation expectations, and international competition were helping to restrain unit labor costs and price pressures. Nonetheless, meeting participants generally remained concerned about the risk that possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, could add to inflation pressures."
  4. OK. FINALLY. Nearing the end of the notes, a quote that seems to say something about the Fed's feelings on the current pace of rate hikes: "It was also noted that an abrupt rise in long-term interest rates, reflecting, for example, a reversion of currently low term premiums to more typical levels, could weigh on both household and business spending." Now, how would rates rise abruptly? It is not clear. But given the Fed is only jacking us a quarter of a point at a time, I suspect the Fed is not talking about providing the spark directly. Regardless, this hardly seems to express concern over the current pace or trajectory of rate hikes.
  5. All inflation indicators remain well under control, even if the Fed may be a bit confused by it. "In their discussion of prices, participants indicated that data over the intermeeting period, including measures of inflation expectations, suggested that underlying inflation was not in the process of moving higher....Some meeting participants expressed surprise at how little of the previous rise in energy prices appeared to have passed through into core inflation measures. However, with energy prices remaining high, and prices of some other commodities continuing to rise, the risk of at least a temporary impact on core inflation remained a concern. Participants noted that there were as yet few signs that any tightness in product and labor markets was adding to inflation pressures. To date, unit labor costs were not placing pressure on inflation, and high profit margins left firms a considerable buffer to absorb cost increases. Moreover, actual and potential competition from abroad could be restraining cost and price pressures, though participants exchanged views on the extent to which conditions in foreign markets might be constraining prices domestically."
  6. Most interestingly, some folks on the Fed think that inflation pressures are actually at the high end of their comfort zone. This does not smack of dovish sentiment to me! "Some participants held that core inflation and inflation expectations were already toward the upper end of the range that they viewed as consistent with price stability, making them particularly vigilant about upside risks to inflation, especially given how costly it might be to bring inflation expectations back down if they were to rise."
  7. Ah, truly FINALLY. The ONE sentence that seemed to get the market all excited: "Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy." Woo-hoo! The whites of the eyes! But before we get too excited, the more dour voices on the Fed reminded everyone that " current circumstances, checking upside risks to inflation was important to sustaining good economic performance. The need for further policy firming would be determined by the implications of incoming information for future activity and inflation." My interpretation? The Fed would like to think that the end is near, but they STILL will be following the data. Once this old message gets re-absorbed by the currently giddy market, we should see all manner of stocks selling off again and putting us right back into the churning, upwardly biased trading range we are stuck in.
  8. Lastly, to maintain the suspense, we can clearly observe that there at least two distinct camps in the Fed. On one side, we have the folks who insist that the Fed remain vigilant against inflation suddenly rearing its ugly head as observed through data, and on the other side of the campfire are the folks who want the markets to be clear that the Fed is almost finished. This final quote paints the battle lines well: "Several members were concerned that market participants might not fully appreciate the extent to which future policy action will depend on incoming economic data, especially when an end to the tightening process seems likely to be near. Some members expressed concern that retention of the phrase "some further policy firming may be needed to keep the risks...roughly in balance" could be misconstrued as suggesting that the Committee thought that several further tightening steps were likely to be necessary. Nonetheless, all concurred that the current risk assessment could be retained at this meeting."
So, in my humble opinion, what we have is some new news, but not a lot. The market got reheated over this news, but, as with all past rallies that soared on a few lightly analyzed and over-interpreted Fed words, we should see Tuesday's party get broken up and broken down slowly surely.
However, one continued theme is that the Fed expresses no alarm over the slowdown in housing. They truly see no bubble, just a natural deceleration to a more normalpace of economic activity. For the most part, the market also seems to adopt this lack of alarm. So, nevermind that just a few weeks ago rising new home inventories had folks fearing future pricing weakness. Nevermind that slowing mortgage applications indicated lower potential demand for these rising inventories. Nevermind that the 10-year Treasury is on the verge of breaking a downtrend that has been in place for over a decade. And definitely nevermind that builder after builder has admitted that investors had been inflating the bubble all along and now their rapid exit is pounding out softness in many real estate markets. The power of the immediate flip-flop in sentiment is shown in the market's reaction to the earnings report from D.R. Horton, America's largest homebuilder. reported that DHI talked at length about the rise in incentives in the industry. DHI all but said that they stand ready to meet aggressive builders toe-to-toe and nose-to-nose to maintain their share of the shrinking pie as they leverage their industry-beating low cost of doing business. While I remain relatively confident in the housing stock bottom thesis, it is clear that more bad news is to come for the housing market (for sellers anyway!). The stock was selling off hard and bringing downmost of the other homebuilders until the market chose to give the Fed notes a positive spin. The current low P/Es and price downtrends have accounted for a lot of bad news in the housing sector, but the cushion is starting to run thin. As I stated in an earlier missive, higher rates are the biggest threat now. Sustained 10-year yields over 5% will mean that all bets are off!
In the meantime, be careful out there!

DrDuru, 2006