Thursday, March 22, 2012

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.


Squire said...

I couldn’t agree more but I foresee the rotation & improvements to be slow.

I don’t see upward mobility in the future for say 65% of the population due to structural reasons. Prices for everything are too high for them and will continue so. I don’t see the economy flourishing until the top 35% do really really well and carry the rest at minimal life styles.

Inflation will not help the 65%. And it won’t help the 35% if something isn’t done about automatic cost of living increases that increase the carrying cost the 35% must bear of the 65%.

Benjamin Cole said...

Yes, we are on the cusp of secular bull markets in equities and property.

The Fed and ECB may soon begin to target growth, and not peevishly fixate on inflation.

It may be that a Romney victory and then a more growth-oriented Fed will set off a rally of epic proportions.

However, even with Obama, corporate profits have skyrocketed, and inflation is dead. The Dow is up 60 percent in Obama's watch, while it was down 30 percent in the Bush years.

So, I see a long bull market out there, even with Obama.

McKibbinUSA said...

The Fed sold debt at negative-0.089% yields in a sale of $13 billion of 10-year TIPS -- is anyone listening...?

Donny Baseball said...

The nature of profits in the era of Obama are driven by cost-cutting and reduced interest costs thanks to the Bernanke Fed. These are low quality profits which is why they get a low multiple from investors. Companies are about as lean as they are going to get and borrowing costs are as low as they are going to get, so there is scant room for progress on the earnings front. And companies with capital to invest don't want to be the next Boeing or TransCanada.

An administration that was less intent on degrading the business environment would allow for higher quality earnings - those that flow from growth projects and expanding markets - that would get higher multiples from investors. I highly doubt the presumption that stocks will do well in a second Obama term on their own merits, they may do well as an alternative to bonds which a) expose you to financial repression and b) are grounded on the vanishing creditworthiness of the USA under Obama.