Why Housing bears are wrong (Part 2)
September 19, 2007
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Yesterday's action by the Fed could not have illustrated the point I made in the previous post more clearly. I was expecting the Fed to defend homeowner gains with all helicopters in their disposal, but the reality exceeded my expectations. That was too much, too quick. Home prices were on the rise anyway. A smaller cut would be enough to lift prices 5% to 10%. Apparently, Bernanke felt that was insufficient.
Ok, let's continue this series. Imperial1964 is suggesting that housing will come down in real terms but not in dollar terms. I agree with the second half of his statement: housing will not get cheaper in dollar terms. But what about the real terms? This brings us to
Part 2. Real money vs. funny money.
Prices have grown 10% a year for several years in a row when the official inflation was well under 4%. It is not surprising that the bears expect a reversion to the statistical mean.
I did not care to find a link to the graph which showed that in terms of affordability, housing now costs two times the historical norm. Suffice it to say that I'm well aware of it, and I'm sure our permabears - TMFBent, floridabuilder et al could dig up the exact numbers. This and other similar graphs operate with median incomes, ignoring wealth generation in the upper decile, but otherwise they are accurate.
This affordability problem is a strong bearish indicator, so we should talk about it now. If the spike on the graph that took affordability above 200% (100% being the base level) is only a temporary fluctuation, then we should indeed dump our houses and get into cash, gold, or foreign stocks (becuase not much of economy will be left in the US by the time the market corrects). On the other hand, if the spike had solid underlying reasons, we probably shouldn't worry.
Let us see what causes housing to appreciate faster than the rate of inflation. We start with the assumption that household incomes are always proportional to the GNP. This is not exactly true, but it will do as a rough approximation. When we produce a dollar of GNP, some 70 cents should wind up in the pockets of consumers - from workers to CEOs. The median income figure will not show this becuase the rewards are heavily skewed to the top 10% and even more heavily skewed to the top 1%. Still, a consumer dollar is a consumer dollar, even in the hands of Bill Gates.
Official statistics puts GNP growth somewhere around 4%. By definition, this figure is already adjusted for the CPI, so we must add back inflation to find the nominal growth. To keep our numbers simple, let's also put official inflation at 4%. We are not concerned with minute quantitative details here, only with a bird-eye view. Then the nominal incomes of consumers (wages, government payouts, investment income) should increase 8% every year (sorry, minimum wage earners, you were not invited to the party).
Now, what about the consumer goods that stand behind those dollars? In the good old days (before 1980), the economy was mostly real, so most of that 4% GNP growth meant more Big Macs, more cars, more coffee, etc. Ah, those medieval times! Not any more. Today, we have a more or less constant physical output, and the bulk of growth is concentrated in the "service sector" which produces intangibles, mostly having to do with complex operations that result in changes of ownership of the goods produced in constant amounts by the old-fashioned real sector. In other words, your real consumption grows far less than 4%.
Now, let's talk about affordability. Before you can afford a house, you must buy those necessary items - Big Macs, coffee, cars, and many other things that we now take for granted. There is also the discretionary spending which is not strictly necessary but which you are not going to give up anyway - cigarettes, DVDs, computers, etc. What remains after that is the investment part of your income which you can use to buy gold, coins, houses, stocks, Motley Fool newsletters, and other such things. The problem is that you can't use it to buy more consumer goods because the economy hasn't produced more. This is "funny money". The economy has given it to you under the condition that you invest it somewhere but dont try to spend it, otherwise the economy will develop an indigestion known in the academic circles as hyperinflation. You may have private reservations about it, you may suspect (rightly or wrongly) that some of the assets you're buying are overvalued, but this is the only game in town. The moment you try to divert funny money for consumption, it loses its value.
This is how one should calculate affordability. If in 1980 you could buy a certain fixed amount of assets for all the funny money you've got back then, and now you can buy the same amount of assets for all the funny money you've got today, without having to reduce consumption of your necessary and discretionary items, then affordability hasn't changed even though the asset has appreciated faster than inflation.
Let us see how your investment spending will change with time when the economy goes off its "real" railtrack and starts churning out flows of funny money. We shall be generous to the Bureu of Economic Statistics and assume that as much as one half of our 4% GNP growth is real, representing an actual increase in the volume of production of consumer staples and "tangible" services. Suppose you received $100 the first year, and after all the necassary expences, you're left with $20 to invest in housing. Fast forward one year. Your nominal income has increased to $108. You are still consuming the same busket of products, which has grown 2% in physical volume and 4% in price, so your nominal consumption is now 80*1.02*1.04=$84.87. The investment part of your income is now $108 - $84.87 = $23.13. That's a 15.6% increase vs. last year. This is what you now can afford to spend on housing. Needless to say, the price responds proportionally to the increased demand. We must, however, subtract approximately 1 percentage point to account for the new construction - yes, the housing stock itself grows about 1% a rear. So it becomes possible for real estate to appreciate 14.6% in one year even as the official inflation is still 4%. To a bear, of course, it seems that housing became 10% more expensive (114.6/104=1.10) in real terms, ergo, affordability has worsened. In fact, nothing has changed. The housing market simply plunders you from all the extra money you have left after paying for the necessary expenses. Has done it in 1980, is doing it today, will continue to do it in the future. The reason people fail to realize it is mostly psychological: they were taught to believe in our government and our currency. They see that they must part with $500,000 for a lousy 1-berdroom condo, and they think it's excessive. They don't understand that these $500,000 were never never real money to begin with.
But is there still room for further appreciation as funny money takes up the ever-larger share of our income? Let's rerun the numbers, increasing its share to 40%. So you now receive $100 in year 1, out of which you spend $60 and invest $40. Fast-forward one year. Your new income is again $108. Your new expenses are 60*1.02*1.04=$63.65, and your investment spending goes up to 108-63.65=$44.35, or 10.8%. Subtract 1 percentage point as before. Still a 9.8% increase, well above our 4% inflation! Until all your income is fully redirected to assets, there will still be room for assets to appreciate in "real terms". This is unavoidable as long as your income is largely composed of dollars unsecured by consumer goods.
To which, by the way, houses should belong if you use your common sense. It is very unfortunate that what is by its nature a consumer product ever became an asset in the first place. If the cost of houses were included in the official CPI index, you would realize the full extent of hidden inflation in this country, and the figures would not be pretty.
So, we conclude with
Reason #2: Bears are wrong about affordability because they confuse funny money with real incomes.
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