Doug Kass on Housing Predictions: An Update

At "A Dash" we have frequently cited the work of Doug Kass, a colleague at TheStreet.com.  Even before we contributed to RealMoney, we were paying customers to get Doug's work.   We found it to be a source of trading profits, as long as you understood the perspective.

We were therefore a bit surprised when Doug, writing on RealMoney Silver (where we can make no reply), took issue with our conclusions in an article about a survey.  Discussing reasoning and conclusions is fine, of course, but his comment was completely lacking in substance -- nothing about the article in question!

Instead, Doug engaged in an ad hominem attack.  Here is a key quote:

You (and many others) have been dead wrong on the magnitude of the drop in housing while the housing Cassandras have been dead right. (Just go back to your site and reference your reaction to my housing "hyperbole" several years ago.)

Those are the facts. They are not debatable.

We are delighted to see this statement of the issue.  Since we have no ability to reply where Doug wrote, we will have to write here.  As we have often done in the past, we invite Doug Kass to write something in response.  We promise to publish it without any edits.

Let us examine the quantification question.  But first, a bit of background on the housing issue.

Our Position on Housing

In the days before we were writing on this blog, we sent a quarterly newsletter to our investors.  Here is a quotation from the issue of June, 2005:

Housing

Is there a bubble? We see some disturbing facts, all signs of market tops.
People who were formerly day-traders in stocks or had good jobs in software development are now going into real estate.

If you tried to look at housing like a stock, using a PE ratio (rent/price), the number is about 35, 75% above the historic norm and double that of the major stock market averages.

Average folks with absolutely no real estate experience are buying properties with interest-only mortgages expecting to make their profits on appreciation.

We can smell some toast burning here.

We advised our clients against over-investment in real estate and those who followed our program for individual investors did quite nicely in stocks.  Doug Kass was not the only one seeing a problem in housing; he was just too early -- way too early -- in predicting the impacts.  (Check out Doug's timing here).

The "Batman" Chart

Since the issue is quantification, not direction, a great example to consider is Doug's prediction about personal consumption from a year ago.  He had this impressive chart with a distinctive pattern that we called "Batman" around our office.  The time period and the scales had been adjusted to give a false illusion of a strong correlation.  Here is the original chart.

Doug highlighted this chart in his column multiple times and took it on CNBC calling it a .9 correlation.  Charts of this sort are very dangerous for investors.  They do not understand statistics and causal modeling.  They are especially susceptible to visual evidence.

We reconstructed the data and did the calculations.  In one of the best articles we have ever written, we showed the problem in this analysis from a causal modeling perspective.  We expect this article to have a prominent place in our forthcoming book in the "Misleading Charts" chapter.

The obvious implication was that PCE would rapidly decline to below the 2% growth rate.  We analyzed the intermediate results in this article where we showed that the prediction had failed.  We think that Doug was a victim on this entire story.  Someone sent him this chart -- someone with dubious quantitative skill -- and convinced him to go with it.  He should have renounced it at some point.

Current Chart Update

The most recent evidence, one year after the original article, is even more dramatic.  As one might expect, the lending restrictions of banks have increased dramatically.  The changes are actually off of the scale.  The Fed altered the question to split out lending on qualifying mortgages versus subprime and Alt-A.  Bending over backwards, we have used the prime mortgage series in the chart.

Conclusion

As one can readily see from the chart, the precipitous change in lending standards (Doug used an inverted scale so that tighter standards would match lower PCE) did not result in a similar decline in Personal Consumption.  The direction was correct.  As we stated in the original article this is called a "spurious relationship" by those who do causal modeling.  A weakening economy causes all sorts of effects that do not have a causal relationship.

Doug Kass never cited this chart again, nor did any of the other blogs who picked it up.  The conclusion from this chart is inescapable:

Kass grossly overestimated the impact on Personal Consumption in March, 2007.  As he says, "Those are the facts.  They are not debatable."

Comments

[Griz]

Let's just wait and see if the correlation holds up. Sometimes these things just lag a bit...

[kingofithaki]

most charts are based on after the fact reviews of actualities, which can always be routed to create a non conclusive but visually purported connection. Real Estate has more to do with the herd mentality than most want to admit. The great myth is that people buy homes for current value...nonsense, people buy homes for future value. Is this a good school district, do I have to waste energy with security precautions because of crime, are the local gov't bureaucrats going to try to drive me crazy with insane useless rules, are the traffic patterns in the town going to allow me to get from point a to point b quickly, do my neighbors live the same lifestyle I do. California and Florida(along with the rest of the A/C belt) tend to have problems with growth in that the socioeconomic mixing of various historically non connected groups cripples the sense of community when new parties enter the fray from disparate areas around the country. The group think problem kicks in worse in Florida, which tends to draw from tired beaten down rust belt cities or over the top hyper growth hyper crash latin american countries. This creates extremes, where the growth is too large with luxuriation(i.e.-lazin... and when that fails or outgrows the sustainable demand, the rust belt mentality of the capital holders in Floriduh kicks in, helping to foster the same errors that led to the collapse of the rust belt in the first place. There is no velocity of capital in the rust belt, and that mind set is what holds down the rebirth. Floriduh does suffer from a lack of "pride" based(Hometown ego) large banks or any great universities. It also suffers from a lack of systematic small business growth designed to exponentially expand. California gets great benefit from the funnel effect of all the american jobs that have moved to asia. Overpriced moneycenter cities(NYC, Boston, SF, Chitown) will always seem to be on the verge of collapse when the financial markets take a breather and suddenly toto has pulled back the curtain, but as long as small town america expects conformity to a non american non dynamic existence, there will be people wanting to get away from the same old stale bread and run to hide in the big city. People predicted the end of the world as we know it under the "S & L crisis"(really the California and Texas Bailout plan) where there were quotes of $ 400B as being the probable long term cost, and the much misquoted $160B purported actual cost...the real hard money cost was less than $90 billion...and once the damage was done, the market kicked into gear, stabilized and went forward from there...this mess will last as long as the little banks refuse to drink the kool-aid and merge with the larger banx. This will be quick if they are smart enough to accept convertable prefereds. If not, between now and November 2010 there will be pain(in 2011, Basel 2 kills off the banx who did not play along)...but already in florida, the lenders have taken 50% baths to get inventory moving. Working class homes are for sale in Northern Tampabay for less than 75K again...where rents are about 750-900. In some cases, homes that need minor repair are up for less than $55k. The loan pool is in the 12 trillion dollar range nationally...even a 500B shave over three years is basically just a loss of the profits on the annual spread between cost of funds and yield on the performing portion of the paper held in the tranches. Not everyone in america will end up owning a home...at most we will get to 75% in the future. And nobody shut down the baby making factory twenty years ago...another 2 millions souls looking for a place to call their own...each year...there are those who suggest people will move to the rest of the sunbelt and leave florida hurting...how long before people realize that no one from the rust belt wants to live in the republic of nascar-ia. Dale is not the first word most babies say in buffalo. Look to second tier builders who had not geared up as much as the large players, they will survive, thrive and grow as the ego kicks in and they smell a chance to catch the upper rung. It's all about emotions...follow the PR campaigns and you shall see the window of opportunity...ask why the group that attacked countrywide(naca and others) is in bed with Paulson & co who helped create this naked shorting on derivatives...foolish mortals, yabin playd.

[User 174119]

I have no idea what this article was about. It dealt with so much 'inside-scoop' that not being on the inside, I just didn't understand anything. It looks like there was some disagreement between 2 parties on the Real Estate issue...Boring

[Mazel Tov]

Look, there is nothing good going on in the housing market at this point in time. Is it at a bottom? Probably not since the list of comparables continues to show housing sale prices continuing to drop. I think using technical analysis and comparisons to the tech bubble is a load of crap. People that invested in tech stocks were not taking out ARMs of $500,000+ loans to make a purchase. We still have at least 6 months to 1 year of depreciation until a bottom out of this market. Just wait and see!

[gordon]

Homeowners took out $250 BILLION in 2007 in home equity withdrawls, and 80% of refis in the 4th quarter still included cash out. You are talking about PCE (Personal Consumption Expenditures) that LAG! The 4th Q 2007 marked the end of this nonsense, since then lenders HAVE CANCELED HOME EQUITY LINES OF CREDIT, where the borrower has negative equity in the home. A lot has pummeled the borrowers since then, not the least is flat wages and layoffs. So, Kass is early, that's better than being wrong, if you are predicting a flattening out of PCE or rise, you are just that, imo.

[Doug Roberts]

Hi Jeff -
I enjoyed this post. I read your columns regularly and enjoy them. I know of Doug Kass but do not read him. I have heard good things about him. Given the large number of posts I read that make few useful points, I found this one enjoyable. Thank you. - Doug Roberts

[The OnlyAnswer]

There is no doubt that we are currently in the early innings of a global financial crisis. The FED is doing what it can (very little) to control markets and avoiding a crash. Keep the little people from panicking and buy some time. Someone will eventually have the guts to flush the toilet, but up until now the phrase seems to be "not on my watch." Play your cards close to your vest and ride it out as safely as you can. How about a story on LIBOR...it looks ready to blow up soon.

[MattBlackman]

At the end of the day, nobody but you (Jeff Miller) cares about whether you are right and Doug Kass was right or wrong. Besides PCE (and CPI) is pretty much a useless indicator unless you are a Fed minion. If you want to launch such a discussion, take it outside or elsewhere. It is a waste of space here.

[ponchovilla]

At a .9 correlation it's nice to be directionally correct. The rest is a battle of chart titans arguing methodology. These arguments can last for years as the barn burns down and the horse has been made into hamburger.

[jjason]

Jeff, The article is one of your worst. And we do not need any long-winded replies.

[Jeff]

As usual, I appreciate and learn something from all comments. I can see that I should have quoted more from the original article. It seems like most readers are not referencing that analysis. In particular, the difference between the actual correlation (.19) and the visual image is important. I have quite a number of "chart udpate" pieces planned, and I'll try to do better in explaining.

For those who do not think the issue is important, you should talk to some individual investors. This chart had a very powerful effect on people a year ago, with a prediction of an incipient collapse in consumer spending. The "batman" part of it, which is actually not even correlated, is a particularly deceptive feature. And as for "giving it time" the entire scale was manipulated to make the "V" bottoms fit so that the collapse in spending would seem to be an immediate threat a year ago. In the book, the original charts and the updates will be side-by-side, perhaps solving some problems.

Thanks again to all those who took the time to offer constructive comments.

Jeff