EScroogeJr (< 20)

Why housing bears are wrong (Part 2a)

September 27, 2007 – Comments (3)

I have shown in Part 2 that asset prices generally appreciate at a faster rate than either inflation-adjusted or nominal incomes, the reason being that the lion's share of the new money injected into the system is being used by recipients to purchase assets. Let us now examine the same process from the supply viewpoint.

The link to Federal reserve gives you the most current M2 statistics. Digging into the H6 releases (annual seasonal factor review issues), I have compiled the following table:

M2 Percent change at seasonably adjusted annual rates:

2007   6.7    (first 6 months)

2006   5.3 

2005   4.0 

2004   5.6 

2003   4.5 

2002   6.5 

2001   9.6 

2000   6.2 

1999   6.0 

1998   8.4 

During these 10 years the M2 changed from $4.1 trl to $7.3 trn, or 78%. The average home price was around $170,000 in the beginning of 1998 and reached $306,000 in 2006, according to this source.

Thus, contrary to the permabears' whining about inflated prices, housing managed an 80% growth during this time, practically in line with M2. You pump more money into the system, the price moves sychronously. Miracle? 

The main reason the bears are complaining is that the median household income remained flat (actually, even showed a 2.7% decline, according to Wikipedia) in "real", i.e. CPI-adjusted, terms. The CPI changed from 163 in the early 1998 to 201 in the end of 2006, according to the BLS. So the median income grew only 23%. Yes, it does appear that savers are losers. Kudos to Mr. Kiyosaki, or rather, welcome back to Reality 101. But how does that make the housing bubble unsustainable? We've had DJIA grow from 8000 to 14000 during that time - at virtually the same annualized rate as housing. But for some reason nobody predicts a market crash on the grounds that stocks have become too expensive for the US population to afford, and we started out in 1998 at what was a historically pricey valuation. 

I already pointed out in the previous post that people can afford houses because they own houses. This is very similar to the stock market. If everybody kept their savings in a bank, there would be no way the US population could buy all these stocks today. But that's not how it works. Smart people have been putting their savings into stocks, and this is how today's stocks have no trouble finding a buyer. But it's also true that the savers are losing the race. If they came to the market today, with what's left of their savings after the IRS took its cut of the interest they earned on CDs (which were barely keeping them in line with the CPI to begin with), they could afford a substantially smaller piece of the US economy than in 1998.

And may I also suggest that just like stock investors are ready to pay more for KO when they expect inflationary environment, real estate investors may be willing to pay more for houses when anticipate an increase in the money supply? This suggestion seems reasonable to me. After all, we also pay much attention to PEG rather than just looking at the PE. And I must say here, the trend is not very encouraging. Not to mention the M2 spike early this year even before the liquidity injections and the rate cut, there is the fact that M3 has been growing even faster than M2.

M3 Percent change at seasonably adjusted annual rates:

2005   7.8 

2004   6.2

2003   3.4

2002   6.4

2001   11.5

2000   8.6

1999   7.6

1998   10.9

This is not exactly a delayed inflation because this this money is not necessarily destined to wind up in the hands of American consumers, but it certainly creates a potential for inflation. I must confess that the table above is incomplete. The reason is that the Fed has recently stopped publication of M3 data under the official pretext that it costs them too much money to gather this data (sic!). Fortunately, this indicator can still be reconstructed from the data that is available. I recommend everybody to look at this chart and observe how confidently the M3 graph is breaking through the 10% threshold.

Anyway, there is really no need to speculate on what the Fed is hiding from us. There is a general consensus shared by Wall Street and ordinary consumers that we are entering into the next inflationary spiral, that the Fed will be easing again and new rate cuts are not out of the question. Buying assets today makes as much sense as it did in 1998.

Thus, based on fundamentals, there isn't and never has been any housing bubble. It's the monetary supply, stupid.