Once again we look at one of my favorite analysts and behavioral finance thinker, James Montier of Dresdner Kleinwort Wasserstein in London. James wrote a fascinating book several years ago called "Behavioural Finance: A User's Guide" and puts out ongoing research like the one we will enjoy today. Long time readers will recognize the name because I have discussed many of his ideas in my weekly letter "Thoughts From the Frontline," my book "Bull's Eye Investing" and in "Outside the Box."
This report by James explores whether there is a bubble in the US housing market. He has pulled together data from numerous sources and gives his conclusion that there is a definite bubble. In fact he does not understand how others like myself could argue otherwise and that is why it was picked for this weeks Outside the Box.
- John Mauldin
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Pictures of a mania? - US Housing
By James Montier
June 20, 2005
First, let me confess my ignorance, I know very little about housing. However, I do know something about bubbles and something about psychology. The debate over the possibility of a US housing bubble raging in almost every paper, and even within the exalted shrine of the Federal Reserve Board, has prompted me to take a cursory glance at the housing market to see if I could spot signs of a speculative mania.
Frankly I am amazed there is even a debate. All I can see are signs of speculative excess. Let me take you through the key pieces of evidence for the prosecution which, I believe, represent a prima facie case that a bubble exists.
Firstly, the near-exponential rate of price increases that characterise bubble behaviour are clearly visible in the chart below.
However, prices alone don't define a bubble. Rather it is the deviation of prices from their fundamental value that truly create a bubble. The chart below shows the 'PE' ratio for US housing. It is constructed as the ratio of house prices to rental income. Once again the exponential explosion that is so typical of a bubble can clearly be seen. Either historically, housing has been remarkably undervalued (unlikely, we suspect), or prices have been driven way out of line with underlying values.
Of course, people don't think about housing in this fashion. Instead people tend to think about housing in terms of affordability. That is to say, most people examine housing in terms of the amount of their monthly salary that will be consumed by the mortgage. This might sound perfectly reasonable, but it flies in the face of the rational investor's view of the world.
The chart below shows the interest rate on a typical 30-year mortgage with 10% down, as a proxy for the average interest rate facing homeowners. It also shows the household mortgage debt payments as a percentage of disposable personal income as calculated by the Federal Reserve Board in their flow of funds statistics. Despite the near record low interest rates that home owners are enjoying, the repayments have soared to over 10% of monthly income!
An alternative source shows an even higher percentage of income going on mortgage repayments. According to the Joint Center for Housing Studies (JCHS) at Harvard University, after-tax mortgage payments consume nearly 20% of income. The JCHS also found that nearly one in three are now spending more than one third of their monthly salary on mortgage rates. Around 10% of Americans spend more than 50% of their monthly income on mortgage repayments!
Evidence of loosening standards is also fairly typical of a bubble. For instance, investors were happy to buy firms with no track record of earnings and value them on the basis of clicks and eyeballs during the dot.com years. Within the housing market we can find evidence of a general easing of standards. The percentage of loans with a loan to price ratio above 90% is 18%. New measures of financing have become increasingly popular. 35% of mortgages are now adjustable rates (ARMS) leaving borrowers very vulnerable to rising rates. Perhaps the US homeowner has bought into our Ice Age philosophy, but we doubt it.
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Other exotic mortgage types have become increasing common. Interest-only mortgages are now commonplace. Negative amortisation loans are easily available. These beasts allow buyers to pay less than the interest due, and the balance is then added to the principal repayment. Indeed 105% loan to value mortgages are also available, so buyers can cover the costs of buying!
Indeed even the bubble blowers who run the Fed seem to be getting increasingly nervous about the state of play in the housing market. Susan Schmidt Bies gave a speech (Current Regulatory Issues, June 14 2005 Remarks by Susan Schmidt Bies) recently in which she stated: We see indications that underwriting standards are beginning to weaken. For example, "affordability products" - such as interest-only loans, negative amortizations, and second mortgages with high loan-to-value ratios - are becoming more popular; sub-prime lending is growing faster than prime lending; adjustable-rate mortgages, or ARMs, have grown substantially and now account for more than a third of all mortgage originations, the highest level since 1994. Industry experts are increasingly concerned about the quality of collateral valuations relied upon in home equity lending and residential refinancing activities.
As Bies noted, sub prime (lending to those with blemished credit histories or unusually high debt to income ratios) lending has seen a meteoric rise. The evidence of a slippage of credit standards doesn't come much clearer than this. Sub-prime lending now accounts for nearly 17% of all home equity lending.
Another tell-tale sign of an investment mania is the generally relaxed nature of those investing in the asset in question. William Goetzmann and Ravi Dhar from Yale University have just completed a major survey of institutional perspectives on real estate investing (Goetzmann and Dhar (2005) Institutional perspectives on real estate investing: the role of risk and uncertainty, available from www.ssrn.com
. 200 Funds took part in the survey).
They reveal some unsettling attitudes towards property investing. A couple of questions in particular are highly relevant to our discussion here. Firstly, they asked investors how comfortable they were at extrapolating past returns into the future across a wide range of assets. Investors were most relaxed about extrapolating fixed income returns into the future, then came equity and then real estate. Bubbles of belief (see Global Equity Strategy
, 12 January 2004 for a discussion on the taxonomy of bubbles) tend to be characterised by investors extrapolating past returns into the future, so the prevalence of professional investors willing to do precisely that is disturbing.
The second question of relevance to us is the percentage of investors who think that a crash is either 'not at all likely' or 'not too likely'. As the chart below shows, investors still have tremendous faith in fixed income with nearly 65% believing a crash is unlikely. 50% think a crash in real estate is unlikely, and 30% think a crash in equities is unlikely. The high percentage of those who think a crash in real estate is unlikely is surprising given the immense amount of press coverage that housing market seems to be generating!
The final question of use to us in the current context is an examination of the top factors influencing real estate allocation decisions. The top three factors citied were "statistical estimates of risk and return", "long-term historical performance" and "advice from external consultants". So these investors are essentially extrapolating the past on the basis of advice from the guys who told them to be 80% in equities during the dot com years - well that is alright then!
The final characteristic of a bubble is people buying simply because prices are going up (the greater fool element). According to the National Association of Realtors, 23% of all home purchased in 2004 were for investment, while another 13% were vacation homes! They also found that 92% of all second homebuyers saw their property as a good investment. 38% said it was very likely they'd purchase another home within two years!
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A simple but worrying proxy for speculative buying in the housing market can be found by looking at the number of new houses that have been sold but are not yet under construction. This category now accounts for 40% of all new home sales!
Surely this evidence amounts to a prima facie
case that the US housing market is undergoing a bubble. The bulls rely on arguments on immigration and demographics to support their views. But with a home ownership rate of 70% these amount to little more than betting that prices will keep rising. Of course, bubbles can and do run for longer than everyone expects them to do. But the US housing market is looking increasingly vulnerable to any change in 'fundamentals' (interest rates and unemployment) or sentiment.
I hope you enjoyed Montier's critique of the US housing market.
Your wishing we had a bubble in Texas real estate analyst,
John F. Mauldinjohnmauldin@investorsinsight.com
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07-04-2005 2:44 AM