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I’ve long predicted that housing prices would revert to their mean. The popular chart that depicts this long-term mean is the Case Shiller inflation adjusted housing chart (see first or second chart below).

The logic here is not terribly complex. In addition to the supply/demand imbalance, housing prices must revert to their mean for the simple reason that prices tend to have a very high correlation with inflation rates. Inflation rates, by definition, tend to have a very high correlation with wages. Since house purchases comprise such a substantial amount of the household balance sheet it makes sense for this correlation to remain very tight over any given period of time.

It is practically impossible for housing prices to revert from their inflation adjusted mean for any significant period of time. This is taking a complex argument and simplifying it far too much, but Gary Shilling recently expanded on this mean mean reversion that is likely to continue in housing (via Business Insider):

This huge and growing surplus inventory of houses will probably depress prices considerably from here, perhaps another 20% over the next several years. That would bring the total decline from the first quarter 2006 peak to 42%.This may sound like a lot, but it would return single-family house prices, corrected for general inflation and also for the tendency of houses to increase in size over time, back to the flat trend that has held since 1890 (Chart 26).

We are strong believers in reversions to the mean, especially when it has held for over a century and through so many huge changes in the economy in those years—two world wars and the 1930s Depression, the leap in government regulation and involvement in the economy, the economic transformation from an agricultural base to manufacturing and then to services, the post- World War II population shift from cities to suburbs, the western and southern transfer of population and economic strength, the movement from renting to homeownership and the accompanying spreading of mortgage financing, etc.

Furthermore, our forecast of another 20% fall in house prices may be conservative. Prices may well end up back on their long- term trendline (Chart 26), but fall below in the meanwhile. Just as they way overshot the trend on the way up, they may do so on the way down, as is often the case in cycles. Furthermore, another big house price decline will spike delinquencies and foreclosures leading to more REO sales by lenders,whichwillfurtherdepress prices. Our analysis indicates that a further 20% drop in prices will push the number of homeowners who are under water from 23% to 40%, resulting in more strategic defaults, more REO, etc.

This month’s Dallas Fed Economic Letter also discussed the phenomenon of mean reversion in housing:

As gauged by an aggregate of housing indexes dating to 1890, real home prices rose 85 percent to their highest level in August 2006. They have since declined 33 percent, falling short of most predictions for a cumulative correction of at least 40 percent.[1] In fact, home prices still must fall 23 percent if they are to revert to their long-term mean (Chart 1). The Federal Reserve’s purchases of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) government-sponsored-entity bonds, which eased mortgage rates, supported home prices. Other measures included mortgage modification plans, which deferred foreclosures, and tax credits, which boosted entry-level home sales.

(Click to enlarge)

The government has thrown everything it has at the housing price decline. But as the housing tax credit recently proved, there is little the government can do to stop this inevitable and entirely necessary market adjustment.

The Dallas Fed expanded on the difficulties that the housing market confronts:

Measuring the success of these efforts is important to determining the trajectory of the economic recovery and providing policymakers with a blueprint for future action. New-home sales data, though extremely volatile, are considered a leading indicator for the overall housing market. Since expiration of the home-purchase tax credit in April, sales have fallen 40 percent to an average seasonally adjusted, annualized rate of 283,000 units. This contrasts with the three years through mid-2006 when monthly sales averaged 1.2 million on an annual basis. Before the housing boom and bust, single-family home sales ran at half that pace. Because current sales are at one-fifth of the 2005 peak, new-home inventories—now at a 42-year low—still represent an 8.6-month supply. An inventory of five to six months suggests a balanced market; home prices tend to decline until that level is achieved.

One factor inhibiting the new-home market is a growing supply of existing units. The 3.9 million homes listed in October represent a 10.5-month supply. One in five mortgage holders owes more than the home is worth, an impediment that could hinder refinancings in the next year, when a fresh wave of adjustable-rate mortgages is due to reset. The number of listed homes, in other words, is at risk of growing further. This so-called shadow inventory incorporates mortgages at high risk of default; adding these to the total implies at least a two-year supply.[2]

The mortgage-servicing industry has struggled with understaffing and burgeoning case volumes. The average number of days past due for loans in the foreclosure process equates to almost 16 months, up 64 percent from the peak of the housing boom. One in six delinquent homeowners who haven’t made a payment in two years is still not in foreclosure.[3] Mounting bottlenecks suggest the shadow inventory will grow in the near term.

Notably, not all homeowners in arrears suffer financial hardship due to unaffordable house payments. Those with significant negative equity in their homes may choose to default even though they can afford to make the payments. Such “strategic default” is inherently difficult to measure; one study found 36 percent of mortgage defaults are strategic.[4] Though the effect is not readily quantifiable, the growing lag between delinquency and foreclosure provides an added inducement for this form of default.

The government has won the battle, but ultimately, they are destined to lose this war with the market. They have attempted to keep “asset prices higher than they otherwise would be,” however, the laws of supply and demand always reinforce themselves over the long-term.

By propping up markets the government has merely kicked the can. The mean reversion will occur one way or another. The government appears to be attempting to ease the markets lower. That is arguably more desirable than crashing prices, but does not mean they will ultimately win the war.

Mean reversion will occur. It’s only a matter of how long we want to drag it out…

Disclosure: No position

Source: Why Housing Is Due to Revert to Mean Price