Blind To Overshooting

The Bear's Lair: Blind To Overshooting

By Martin Hutchinson | 6 September 2008

The Case-Shiller Index of US house prices announced last week, down 17% in the top 10 markets, was greeted with rapture by the stock market, because its rate of decline had slowed somewhat compared to the previous month. Reams of analysis were written about how house prices were nearing the bottom, which was taken to be the level at which the ratio of house prices to individual earnings was the 3.2 times average over the last 30 years, rather than the 4.5 times shown at the peak. However, analysts were as usual over-optimistic— haven't they ever heard of overshooting? Wall Street analysts and the media generally have a poor sense of how the business cycle works. Thus the optimistic revised figure of 3.3% for second-quarter GDP growth was described by several commentators as the "top for this cycle". What cycle? The 3.3% growth figure, caused largely by the tax rebates paid out during the quarter, was preceded by two quarters of almost zero growth and will almost certainly be followed by two quarters of very low or negative growth. There's no cycle there, it's just a blip.

The US$115 billion growth in real gross domestic product (GDP) during the quarter was less than the $120 billion of tax rebates handed out during the quarter, a large portion of which was spent. In the third quarter, there will be no such tax rebates, so GDP growth is likely to be negative. Housing numbers announced this week caused similar optimism. The Case-Shiller price index, down 17% over the last 12 months, was down only 0.6% over the last month, leading analysts to chortle that the housing market decline was coming to an end. After all, with a 20% decline in house prices and 10% rise in general prices (normally a close proxy for wages) over the past two years, the ratio of house prices to earnings must have dropped from its peak of 4.5 times to quite close to its long term average of 3.2 times.

A moment's thought should convince us that this trajectory is unlikely. Mortgage conditions are not those in which the long-term average was attained. Not only have subprime mortgages as a category disappeared, but so has much of the mortgage securitization market as a whole. The government-backed mortgage behemoths Fannie Mae and Freddie Mac have subsided effectively into bankruptcy and will not be buying mortgages aggressively in the future. Mortgages have become very difficult indeed to obtain for anyone with a credit score of under 700 or so and generally require a down payment of a full 20% of the purchase price.

On the other side of the equation, home-buyer psychology has completely changed. No longer is it expected that house prices will continue a steady and inexorable rise, without significant downdrafts. Buyers now know that if they need to move again in a hurry, they may well be lumbered with an asset that will prove impossible to sell except at a price that wipes out of most or all of their original investment.

With mortgage markets much more difficult than their long-term average, and home buyers much more nervous and pessimistic than their average, it is hardly to be expected that house prices will stabilize around their long-term equilibrium level. Only interest rates, still exceptionally low in real terms, will tend to hold them up. However, since interest rates will eventually need to be raised to combat inflation, that sustaining force also will be removed from the market.

At that point, house prices will decline, not to their equilibrium level but to some much lower nadir. The further drop will itself tend to depress mortgage activity and investor sentiment. The model could be Japan, where real-estate prices dropped around 60% from the 1990 high, with further drops extending to 80% in downtown Tokyo. Since Japan is an island chain of dense population and limited buildable land, real estate prices should always be high and might be thought immune to such fluctuations; the experience of 1990-2005 proved that if a deep recession took hold, there might be very little restraint on the downside.

Some areas seem more likely to suffer such a prolonged downturn than others. In Britain, there seems little reason why the top end of the London property market should not drop by 50%, or even 75%— the latter would be an overshoot, given London's attractions as a commercial and financial center, but only a modest one. Needless to say, any such drop would take place only over a decade or so, and would be accompanied by enormous pain in the home mortgage market and indeed in the lives of London homeowners, who would have sink their entire future into an overpriced and declining asset.

A movement of similar depth seems likely in the United States only in the most speculative areas. One could imagine, for example, Manhattan and the fashionable San Francisco suburbs suffering such a downturn, as the financial services sector suffered its inevitable lengthy cutbacks (and leftist Manhattan mayors pushed up real-estate taxes inexorably) and the technological leading edge moved from tech to biotech, which is much less concentrated in the San Francisco area. However, it seems unlikely that Washington, for example, will suffer more than a moderate downturn, as the growth of government and its accompanying miasma of corrupt lobbyists, lawyers and contractors is more or less everlasting.

Nevertheless, a national price decline of 30-35% seems easily possible, taking the house price-to-earnings ratio below 3.2 times to a bottom in the 2.5 times range. At that point, unlike in the more crowded Japan and Britain, the availability of attractively priced real estate in outer suburbs and the heartland, where prices had remained much more affordable, will bring new buyers into the market. These new buyers will be easily able to fulfill the prevailing tighter mortgage standards and will see home ownership as a financially attractive alternative to renting, whatever the behavior of house prices.

Overshooting need not be confined to the real estate market. It already seems to be happening in some bond markets, as prices of apparently solid housing-related assets decline to 25% or less of their principal amount. Now we are seeing a broadening of spreads in the emerging market bond market. Unlike emerging market stock markets, which include the world's most exciting growth stories, emerging market bond markets contain primarily credits to whom a sensible person would not lend.

More than two-thirds of the Morgan Stanley Emerging Market Bond Index is devoted to Latin America or Russia, all highly doubtful credits with bad political management, with the exceptions of Brazil (still over-borrowed and vulnerable to a commodities downturn, but with competent economic management) and Colombia (highly competent management, but continued political risk from both the FARC guerillas and the elections due in 2010.) Even removing Brazil and Colombia, almost half the EMBI bond index is of poor quality; hence it is reasonable that spreads are finally widening. It is also reasonable to expect a cascade effect on credit quality, as the wider spreads begin to restrict loan availability and the restricted availability of new money begins to cause economic difficulties among borrowers.

In the end, it is likely that the market will again overshoot, as it did in the early 1980s, so that even well-run countries like Brazil and Colombia, or adequately run non-Latin countries like Turkey and Indonesia, will be forced into default simply by the absence of new bond market financing. In 1982, Mexico was poorly run and deserved to default, but Brazil was quite well run and could have survived default had the bond market remained open. Needless to say, the world's stock markets will not be exempt from the overshoot phenomenon. So far, only a few emerging markets, notably China, have experienced any significant downturn. In the West, stock prices are generally still well above those prevailing in 2006, considered at the time a boom year.

However, when the decline does finally come, it will be severe. Inflating the early 1995 Dow Jones Industrial Index level of around 4,000 by the increase in nominal GDP since then gives a value of 7,800 today, which may be considered the stock market equivalent of the 3.2 times house price-to-earnings ratio that is considered equilibrium in the housing market. Needless to say, even a drop to 7,800 would cause consternation and hand-wringing among Wall Street and investors generally. It should be noted however that 7,800 is the equilibrium level for stocks, not a prediction for the bottom, which must of necessity be much lower, as price declines reinforce negative investor psychology and pessimism; 5,000, or even 4,000 would seem reasonable predictions for the Dow's low.

Given the economic changes involved, the market may well take close to a decade to get there. After all Japan, subject to a similar bubble in 1990, took 13 years to reach its low on the Nikkei, which at 7,603 in April 2003 was 81% below its December 1989 high of 38,916. The 13 years and four months of the Japanese downturn would, measured from the true peak in market psychology of March 2000, take us to July 2013.

The overshoot phenomenon means we are not yet halfway through the current downturn, even in housing. It is most unlikely that deflation of the 1995-2007 asset price bubble will be accomplished in less than five years, since its deflation will be fought every inch of the way by politicians and Wall Street. Maybe we should start buying in summer 2012, but 2013 would be safer.

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Normxxx    
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