Parallels Between Stock and Real Estate Excess Valuation

The apparent excess valuation of home prices is approximately equal to the recent apparent excess valuation of stocks.

As the S&P 500 was trading in the 800 area just a week ago, we were writing about a highly likely S&P 500 drop to 700 (about 12.5% down), and a realistic chance of a drop to 600 (a 25% drop), and some more severe possibilities. The 700 level is based on reaching just below the 2002 low. The 600 level is based on 15 times the 2010 S&P 500 “as reported” earnings projected by Standard and Poor’s.

This week's Barron’s published a chart from the National Association of Realtors showing the ratio of median home prices to median household income since 1965.

We added some horizontal lines to show that a drop from the current 3.2 ratio to the most common ratio of 2.8 would be a 12.5% decline. A change to the 2.4 ratio experienced in 1970 would require a 25% fall in home prices.

It is interesting to see the similarities in recent excess valuation. However, it is discouraging to know that plausible to probable 12% to 25% reductions in home prices would certainly have a widespread and deep impact on the overall economy, and also kick the stock market even further down the stairs.

While weak stock earnings projections and normalized P/E ratios lead to the conclusion that stock prices must fall more, the visibility of household wealth declines makes hope for positive stock market moves all the more distant.

Let’s hope that rising corporate earnings and rising wages will partly offset the price declines that would be necessary to restore normalized ratios of prices to earnings and wages.

Comments

[User 345523:]

So, we're in for more pain as we adjust to the mean...something like that, right?

The only problem I have with these charts is how certain everyone is that a revision to the mean is an economic certainty. That somehow we (American home owner) can't possibly wind up above the 2.8 number in this case. I just don't think there's enough thought on the topic if we stop there and treat this like it's Newton's law of gravity.

I go back in time and think about the house I lived in, and what my parents lived in (probably a so-on and so-on tale). Let me say, none of those homes are the same, or comparable. 1300 sq. ft became 1900 sq. ft., and now it becomes 2400 for my generation (speaking broadly). Formica (which was once a big new deal) has well given way to granite. Technology has changed (improved) the useable life of a modern built home. The list goes on and on of improvements.

Yet, here’s another article that points out how we’re suffering from ‘excess valuation’. Before we all jump into ocean from a dry boat, I ask “why is the home price not valued correctly now?” That is to say that, why shouldn’t homes be more valuable than they were in 1970? Aren’t we getting more value on average for the homes that are built today (recently)?

The market went through a credit induced bubble, no doubt, but that doesn’t mean that he *have* to end up where (or below) we started from. Isn’t it possible that our culture has changed in the last 30 or 40 years? Can’t it be that people value home living space more than some of the other discretionary purchase decisions that previous generations indulged in (like more children per household)? If so, then can’t we solve the denominator side of this equation with a simple acknowledgement that people can want nicer homes and are willing to dedicate a larger share of their income to it than ever before? Wouldn’t that leave this ratio at a sustained higher level?

There’s obviously a point where people do not have the feasibility to meet the payment, primarily when under economic hardship, but that still an on the margin argument to make. In general, a shift in culture (and technology) has prompted a shift in construction. I just don’t see why we have to conclude it doesn’t mean a shift in purchase decisions.

Feb 23 01:47 PM

[QVM Group:]

345523:

Your point is interesting. We don't have to assume anything, but it could be useful to assume something. Given that return to mean is more probable than establishing a new mean, and given that the current level of housing appears to be unaffordable -- even before the crash (just look at all the communities worried about their children not being able to ever live in the town in which they live with parents due to high home prices).

You may be correct, but assuming that you are is no more valid than assuming you are not correct. In the context of asset deflation all around us and the better odds betting on mean reversion than a new paradigm, I would continue to be comfortable to say homes are overvalued, new space and technology standards or not. Regardless of culture, ability to make the purchase and leverage payments is always a limiting factor.

Feb 23 06:35 PM

[ozcutty2:]

Even 3.26 is much cheaper than UK. Here im Australia, ratio is about 7-8x income, crazy eh?

Feb 23 10:05 PM

[mallarde:]

The prices have not really adjusted down yet. The median prices we see are skewed low because many of the sales are distressed sales whereas owners in nicer areas are holding and and refusing to sell.

Median prices might stabilize, but only because the mix of sales will be less distressed sales and more non-distressed sales.

Feb 23 10:21 PM

[Fabien Hug:]

User 345 523 makes an interesting statement but median income have also increased. I think the relation and a return to the mean is still in the cards. I don't really know about housing but 42 years ago, when my father bought our first car, a beetle, it was a huge expense, paid in cash with the last five Swiss cents in coins on the dealer table. Now, a relatively nice sedan is easily within reach of a working family and it will need proportionally much less of the household income to afford. I think same is valid for houses.

Feb 24 12:03 AM

[scotty1560:]

Real Estate in South Florida is down 50% and will end up at 75-80% from
peak. A 500k home 3 years ago is now 200k, and last spring was probably
350k, it's happening so fast you can't get out of the way and there is
no liquidation price that seems to move properties. Looks like 1995-1998
prices will be here within 2-3 summers.

How many people in the last 10-15 years will lose their credit, their home,
their income. How many middle aged and older aged people are now permantly
destroyed, no savings, diminished income. How many families are headed
for the streets.. I know quite a few.

Falling prices are great to an extent.. however the flip side is you lose your
job or if you are in sales you no longer are selling. So massive corrections
wipe out an entire generation or two. Anyone with retirement accounts
is wiped out.. bubbles and the aftermath of bubbles is lethal stuff.

Feb 24 11:43 AM

[SeekingTruth:]

Thanks, Richard, for continuing to cut thru all the fluff and fog of stock market static and noise with your solid numbers and analysis.

Many investors that do not have money to burn (or tie up for years) will do well to heed your notes of caution based on solid data and evidence.

Feb 24 09:39 PM