A Tale of Two Housing Markets

It is important to remember that while there has been a great run-up in housing prices in recent years, there have been large parts of the country that saw little of the boom.

Part of the reason for this is because there have always been two housing markets, one in major (usually coastal) cities where supply is constrained (relatively inelastic, like Manhattan). In this case housing demand (ultimately disposable income) drives housing prices.

In other parts of the country, land is freely available for development and increasing prices only lead to increased housing construction (relatively elastic supply). Over the long term, housing prices closely track the cost of increasing supply - the cost of construction (and factors like lumber prices or the wages of Joe the Plumber).

ON the Bubble Overall:

In terms of the bubble overall, easy access to credit due to lower quality lending, a permissive interest rate environment and an influx of foreign buyers during a period of dollar weakness, all combined to push many cities above historic norms. These forces were probably most felt in major coastal cities (though limited increases in supply during this period may limit the eventual fall).

However, these variables can only lead to one-off increases in prices and not continually higher prices (e.g. interest rates can at best eventually fall to zero, exchange rates shift and foreign investors also eventually find prices to high for their incomes). If prices continually rise above income, eventually a point is reached where virtually all of the typical household's income goes to housing and no new buyers are available.

Most curious to note are cases like Miami and Los Vegas that saw large price increases in that they are not supply constrained. Drive north along the coast from Miami or survey the area from Google maps and one sees large tracts of land still available for development, even on the water. Similarly, a shorter commute can support relatively higher prices in the more central neighborhoods of Los Vegas, but are hard to sustain if prices are much lower just a short drive away to cheaper, new construction. In both cities, as prices increased dramatically in recent years, so did construction and many of those units are just now coming onto the markets (supply increasing just as demand drops = collapsing prices).

Predictions for the future - Prof. Roubini predicts extended stock declines (TV interview)

Corporate Profits and Stock Prices

In the long term, stock prices reflect the earnings (profits) of companies. When asking why the stock market is down and when it is likely to recover, this chart is handy to remember. From the latest monthly economic indicator report published by the Joint Economic Committee of Congress (and prepared by the President's Council of Economic Advisers).

http://www.gpoaccess.gov/indicators/index.html

If we assume that stock prices reflect earnings (P/E values matter), prices will follow earnings...

Looking forward, as earnings start to recover, stocks may look quite attractive. See a Wall Street Journal graphic on global P/E rates below. Article is here.

Please note that there are two issues in trying to determine whether stocks are cheap or not. First, what is the P/E ratio below which stocks appear attractive? The chart below uses a long-term average (in green), but this is always open to question. Second, how do you measure earnings (trailing of the last 12 months, forward looking over the next 12 months, or using some moving average combining past, present and future earnings). Forward looking earnings are very inaccurate, earnings and earnings projections at the peak of the business cycle are naturally much higher than they are at the bottom of a cycle. Also do you look at operating earnings or some adjusted form of earnings. So different choices in measuring earnings yield widely different results in the measurements of P/E ratios.





According to S&P, the combined 12 month trailing earnings for the S&P 500 as of Sept 2008 was $52.67. So simply divide the closing value of index on any given day by that earnings value to get a quick P/E estimate. On the close of markets on Oct 27th, the S&P 500 was about 850 and the P/E ratio was about 16. By Halloween (10/31) it was 968 and so the P/E ratio was over 18. But stock markets are about projecting forward and guessing when earnings will rebound and to what level is the real challenge.

Here is link to another good chart looking at P/E ratios historically (from Ned Davis Research).

Here is a matrix showing different prices varying P/E ratios and projected earnings for the S&P 500 (forward looking for 2009) from the
Bespoke Investment Group.