The aftermath of the housing bubble looks good for equities

Back in the early 1980s, when I was working for him at Claremont Economics Institute, John Rutledge came up with a version of this chart. He used it to argue that relative prices of things can and do change as inflation fundamentals change. With inflation soaring throughout the 1970s, households responded by attempting to increase their holdings of tangible assets. That's a rational response, since tangible assets tend to hold their value during periods of inflation, whereas financial assets (especially bonds) tend to lose their value. The attempt by households to increase their tangible asset exposure was most noticeable in the real estate market, and it resulted in a sharp rise in housing prices relative to the prices of financial assets (indeed, bond prices collapsed and stock prices went sideways). When inflation began to fall in the early 1980s, he argued that households would reverse their earlier plunge into real estate, with the result that financial asset prices would experience a boom. And he was right.

In updating his chart, I'm struck by how the surge in real estate prices in the early 2000s was not accompanied by rising inflation. It was a bubble that was inflated not by the desire to acquire inflation protection, as happened during the 1970s, but by other factors, such as the invention of mortgages that required little or no down payment or documentation, and creative financing options like interest-only or negative-am loans. It was a massive leveraging-up spree that inflated the housing bubble.

The chart now suggests that housing prices have come back down to earth, and are consistent with the relatively low and stable inflation of the past two decades. In the process of coming back down to earth, the sudden collapse of the housing market and the ensuing financial panic of late 2008 sent households scurrying for the shelter of savings deposits (up over $2 trillion in the past three years), and for the relative safety of bonds—everyone wanted to deleverage and de-risk. That phase is winding down now, however, and the next phase is underway. As households regain confidence in the economy, they are beginning to attempt to shift the money socked away in savings accounts and bonds into both housing (which has become incredibly cheap given the plunge in financing costs) and equities. That's why we're likely to see rising housing prices, rising equity prices, and falling Treasury bond prices in coming years. A shift in households' desired portfolio holdings could create more than enough demand to absorb all the foreclosed houses that banks may end up dumping on the market.

It's not that all the cash on the sidelines goes into the equity market, it's that the desire of households and investors to shift the composition of their portfolios causes a change in relative prices. If the urge to reduce cash holdings is strong enough, and if the Fed doesn't act to offset the decline in the demand for money (by raising rates) this process could fuel a rise in a wide range of prices, and this could show up as higher inflation.