Houses and Commodities
Below is an extract from a commentary originally posted at www.speculative-investor.com on 11th September 2005.
We have little doubt that the US housing market is in bubble' territory. Also, history tells us that all markets are mean reverting; in other words, that a market that moves way above its long-term average valuation is all but guaranteed to eventually move back into line with this long-term average. We can therefore be confident that residential property purchased today is going to deliver poor REAL returns over the coming 10 years. What we can't be confident of, however, is the timing of the inevitable bubble bursting. After all, the great equity bull market of the 1990s took on bubble proportions years before the bull market actually ended. In fact, some of the biggest gains in the prices of tech, telecom and internet stocks occurred after valuations had exceeded the levels reached at previous major stock market peaks. Prices rose to the point where additional upside didn't seem possible, and then just kept on going...and going...and going. We don't know that the same thing will happen with real estate, but we also don't know that it won't.
Based on our belief that real estate valuations are in bubble territory we have assumed that a downturn in prices, or even a substantial slowdown in the rate of price appreciation, would, at this point, mark the start of a major bear market. However, for two reasons we have begun to re-evaluate this belief and to consider the possibility that the real estate bubble could continue to expand for several more years.
The main reason behind the re-assessment of our housing market view relates to our long-term view on commodities; specifically, to our view that commodities are in a secular bull market driven by the effects of inflation on paper currencies. Now, many analysts will tell you that commodity prices have been, and will continue to be, driven higher by China's rapid growth. This is true at a superficial level, but China's rapid growth is being driven by inflation -- the inflation exported by the US via its current account deficit and the inflation resulting from China's own expansion of credit. In fact, because the real cost of producing commodities trends lower over long periods of time and because rising commodity prices limit commodity demand, the ONLY way that a secular bull market can ever occur in the commodity market is in response to inflation.
This causes us to re-think our outlook for house prices because the bull market in real estate is being driven by the same inflation forces that are driving the bull market in commodities. In other words, if we are long-term bulls on commodities due to our well-considered belief that the inflation problem is going to grow over the coming 5 years then how can it possibly make sense for us to expect the real estate bubble to burst within the next 12 months? We know that plenty of people are making the argument that the commodity market will experience inflation while the housing market experiences deflation, but this just demonstrates a lack of understanding of what inflation and deflation are. For the uninitiated, inflation and deflation are economy-wide changes in the supply of money and credit, so it is not possible to have inflation in one sector of the economy and deflation in another. It is quite normal for prices in some sectors of the economy to be pushed sharply higher by inflation while the prices in other sectors rise more slowly or perhaps even fall, but once an asset class begins to benefit from a long-term inflationary trend it will usually keep benefiting until the inflation ends.
The aforementioned link between the long-term bull markets in commodities and real estate is supported by the following chart comparison. The charts show that bull markets in Centex (NYSE: CTX) -- a large homebuilding company that we are using as a proxy for the real estate sector -- and the Commodity-Related Equities Index (CRX) began at roughly the same time and also began to accelerate at roughly the same time. Interestingly and, we think, not coincidentally, the bull markets in commodity-related and housing-related stocks began at around the same time as the NASDAQ's bull market was ending.
One big difference between the commodity and housing markets is that commodity prices are low in real terms whereas house prices are high. This valuation difference probably means that commodities will benefit from future inflation to a much greater extent than real estate, but isn't a good reason to expect the real estate bull market to end as long as the underlying long-term inflation trend remains in place.
The other, and less important, reason for re-evaluating our 2-5 year outlook for residential real estate has to do with the words of caution uttered by Fed Chief Greenspan over the past several months. Throughout his career Greenspan has invariably been wrong at major turning points in the markets, so the fact that he has recently sounded a warning about the upward trend in property prices could be construed as a significant positive. Recall, for example, that Greenspan used the term "irrational exuberance" when referring to the stock market in December of 1996, more than three years prior to the end of the NASDAQ's bull market. In fact, minutes of Fed meetings released years later show that Greenspan was concerned about a stock market bubble as early as 1994. However, when the NASDAQ bubble was at its zenith in March of 2000 there were few stronger proponents of the "new economy" and the technology-driven "productivity miracle" than Mr Greenspan.
Will Greenspan's recent words of warning about the 'frothy' real estate market prove to be prescient? Or will this year's bearish murmurings by the Fed Chairman go down in the annals of history alongside his famous "irrational exuberance" speech as a seemingly sensible (based on valuation levels) but ultimately wrong assessment of the situation? If past performance is anything to go by, it will be the latter.
In summary, the more we think about this the less we think it makes sense to expect the commodity bull market to continue until the end of the decade AND to expect the real estate bull market to end anytime soon. We do expect that there will be a shakeout in the commodity market over the coming 12 months and that this shakeout will be substantial enough to convince most people that the long-term bull market in commodities has ended, so perhaps it makes sense to anticipate something similar in the real estate market. In other words, we could well get a large mid-cycle correction in the real estate market over the coming year -- not so much in the average home as in the homebuilding sector of the stock market and those parts of the property market that have experienced the biggest gains -- with the long-term upward trend remaining intact until around the end of the decade.