Beware Unquestionable Financial Beliefs

Understanding the value of something is always a relationship thing. Picking the right relationship is the key to understanding the opportunities/risks provided by a divergence between price and value. Another thing to recognize is that like social relationships, financial relationships can get seriously irrational on either the upside or downside.

One of my favorite relationships is house price values relative to median income. Houses, when viewed in an ecological framework, are physically constrained to a given catchment area. The resources that keep them strong (value wise) are the available incomes in that catchment area.

Rental income to home price ratios are just a sloppy proxy for this relationship. House value isn't a function of replacement value, etc. Detroit with its average home price of <$10,000 should make this point. The relationship is between median incomes in an area and the price of the available homes.

This ratio has historically been about 3:1 in the US. Here is a video showing the US relationship over time. The ratio was temporarily distorted by the magic of securitization, government programs, etc. but has now resorted back to its original relationship of 3:1. Beware of unquestionable financial beliefs. The chart below came from a very useful blog called Sober Look who lifted it from Credit Suisse, who lifted it from DataStream.

The bad news is that median income recently reported a 3.3% decline albeit looking backwards. If this level were sustained it would indicate a further 10% decline in house values' fair value.

Another important factor to consider is that the median figure hides a likely increase in the variance of incomes and regions. This affects the economic and value impacts on 2 axis.

The likelihood of extreme pockets being created with continuing downward spirals such as Detroit is on the geographic data axis. On the time axis the potential for the mean or median to hold over time at 3:1 would statistically indicate potential for overshoot on the downside. In the long run things will stabilize, but a 7 year debt/asset bubble is rarely rectified in a few quarters.

The process known as the great depression had a false dawn about 2 years after the equity market decline.

Given the consumer debt load and new-found interest in a saving behavior, a net contraction of 12-17% in US GDP would not be surprising to me over the next 3-5 years.

The potential for consumer consumption declines or falling to normal (sans housing wealth effect) followed by more fiscal stimulus at the federal level still leads me to speculate if we are in a dollar/ US debt bubble of significant size.

The recent California bond auction is not a dead canary in the coal mine, but certainly a bird with labored breathing.

The ever shortening US government duration (about 4 years now) is worrying. A debt maturity which needs be to rolled over at a faster pace will one day lead to ever increasing auctions. One of those auctions will be an egg, maybe not a Latvian sized egg, but an egg none the less, and that failed auction will be yet another prick in yet another financial bubble. que sera sera.

Comments

[ryanclarke:]

I couldn't find a house in Detroit for $10,000 if my life depended on it. Yes, the banks are selling homes in Detroit for $10K a pop, but they are selling them to charity organizations for $10K so the bank can get a tax deduction... those 10K dumps you hear about in the news are not sold on the open market. Houses sold by the local Detroit realtor are still overpriced ... just like everywhere else ... because the banks across America refuse to let Americans own their home .... they have to pay rent ... for thirty years. In Detroit, it's even worse. IF you can find a good deal, and don't want to renovate the place yourself with housing goods purchased outside the Detroit area ... don't be surprised if the labor is outrageously overpriced compared to ten years ago. That's what happens in a robbing Peter to pay Paul society ... and Paul is dead.

Oct 12 06:57 AM

[Nick Gogerty:]

Here is the report on median house prices in detroit. www.ritholtz.com/blog/.../

Oct 12 08:53 AM

[Moon Kil Woong:]

I suppose that means the government should support rental price stability or inflation as well. They are already supporting banks, autos, insurance, brokerages, government buraucracies, States, unemployment income, artificially low mortgage rates, derivatives, alternative energy, and the stock market through dollar deflation. Am I missing anything else.

Taking this into consideration I suppose we should be Cuba's friend after all. Because we seem to be adding another S to US. The big Question is how we get an extra R to make USSR.

Oct 12 11:29 AM

[Duude:]

That was the median prices back in February and was probably based on an extremely limited number of homes being that we were smack in the middle of the worse of the credit crisis at the time. Regardless, even if the median home price had doubled or tripled from that point it would still be a pretty grim number.

On Oct 12 08:54 AM Nick Gogerty wrote:

> Here is the report on median house prices in detroit. www.ritholtz.com/blog/.../

Oct 12 04:26 PM

[Albertarocks:]

On Oct 12 11:29 AM Moon Kil Woong wrote:

> I suppose that means the government should support rental price stability
> or inflation as well. They are already supporting banks, autos, insurance,
> brokerages, government buraucracies, States, unemployment income,
> artificially low mortgage rates, derivatives, alternative energy,
> and the stock market through dollar deflation. Am I missing anything
> else.
>
> Taking this into consideration I suppose we should be Cuba's friend
> after all. Because we seem to be adding another S to US. The big
> Question is how we get an extra R to make USSR.

You've already got the "R". The United States is a Republic.

Oct 12 06:00 PM

[Smarty_Pants:]

Has anyone done any analysis on the impact of fewer workers in the work force?

The median income level can remain unchanged even when half the workers are fired if the unemployed are ignored in the data. The chart may be depicting an apples vs. oranges comparison over time.

Oct 12 09:33 PM

[tripleblack:]

Of course, dividing virtually NO sales (I heard a recession was going on, but I could be wrong) by any number is going to generate some very odd median "values".

Just divide by zero and come up with, um, let's see, yeah, "zero". Gibberish, really, unless we are talking some Mad Max apocalypse as the "new norm".

As for the income part... Our collective median incomes have taken a hit here lately? Really?

Wow, who woulda thunk it?

Oct 13 08:12 AM