Thursday, January 16, 2020

Housing: Part 359 - Recent shifts in housing may be related to GSE activity

There has been a bit of a mystery recently in housing markets.

Add caption
For a couple of years, the square footage of new homes has been declining.  This could be because of a decline in demand for housing, in general.  Or, it could be from a compositional shift to more entry level homes.  That would be bullish.

Rent inflation remains high, suggesting that demand for shelter remains strong.  Residential investment has levelled off at really low levels.  Rates of homebuilding have levelled off, both in total, and specifically for single family homes.  This suggests that it is a decline in demand (at least for homeownership, if not for shelter) is the cause.  That would point to a retraction in lending markets, or sentiment, or an effect of the progressive housing elements of the 2017 tax law.

There has been a bit of a recent rise in homeownership among young families.  But they are flat among older families.  That calls for some optimism that there is rising demand for entry level homeownership and homebuilding, to meet the existing demand for entry level shelter.  But, the New York Fed's Quarterly Report on Household Debt and Credit doesn't really show any rebound in the number mortgages outstanding or in rising originations among buyers with low FICO scores.  That would suggest that the rebound among young homeowners is limited to those with very good credit.  Yet, if that was the case, why is the average new home size declining?  It could be that young families generally demand smaller homes, even if they are financially secure, because their families are still growing.

I think a clue to what is happening is here, in this AEI update on housing markets.  Here is a slide from AEI.  Notice that at the GSEs, there has been a recent clampdown on high Loan-to-Value and high Debt-to-Income lending.

I suspect that there is a combination of things happening:

1) Some continued tepid improvements in the ability of high-tier buyers to buy or trade-up as equity continues to recover, the economy grows, etc.

2) Still no compositional shift to low tier buyers that have been locked out of the market since 2007.

3) A decline in demand among some subset of those high tier buyers, as a reaction to new tighter standards at the GSEs.  These buyers might be somewhat reducing their demand for units. But the amount they can borrow with conventional loans has been capped by new GSE standards, so they may also be reacting by buying smaller homes.

If this is the case, then I don't think we should be particularly bullish about housing.  I don't think smaller new homes reflect a recovery of low tier borrowing.  But, we also shouldn't be particularly bearish.  The decline in new home size and the levelling off of housing starts may just be a temporary reaction to the change in lending standards to the existing pool of qualified buyers under the current regime.

This might mean that housing will return to a moderate level of growth.  A level of growth that isn't particularly vulnerable to a pullback because there is so much pent up demand for shelter.  And, also a level of growth that could really accelerate with any reasonable expansions in lending standards.  I would call that a bullish expectation in housing, but it's not as bullish as the context where smaller new homes were the result of already expanding the set of potential homebuyers.

PS. This also tweaks my expectations for the broader economy to a more bullish position.  I have posted about how the yield curve is effectively inverted, so that, at least, I expect yields to decline, and possibly some contraction in equity markets or GDP growth.  The pause in housing growth could be a sign of weakening demand, in general.  But, this suggests that it could just be related to a one-time shift in lending standards at the GSEs.

Tuesday, January 14, 2020

December 2019 CPI Update

Not much to say.  More of the same.  Shelter inflation tracking over 3%, non-shelter core around 1.5%, and core CPI about 2.2%.  I don't think short-term inflation fluctuations are very informative at this point, unless they veer wildly in one direction or the other.  I still think the most likely event in the near term is a decline in interest rates, so I am still mostly holding on to bond exposure and keeping powder dry on some potential tactical equity positions, except for positions with some defensive elements.  For instance, Hovnanian, a homebuilder, (HOV) that is highly leveraged, financially and operationally, and poised to recover because of the both defensive and speculative potential of that sector.  I actually consider that position a sort of hedge against a bond position, in part, because I think a primary factor holding yields down is the lack of residential investment.

Monday, January 6, 2020

The 20th Century Equity Sine Wave

A while back, probably even before I started blogging, I noticed that US equities in the 20th century seem to follow a fairly steady sine wave.  This is data that Robert Shiller makes available on historical S&P 500 or equivalent values dating to 1871.  Equity returns were fairly linear before 1900, according to this data.  Here, I use total real returns, which includes dividends and is adjusted for inflation.  That's really the only way you should look at long term index returns.  (The values on the y-axis don't match the current value of the S&P 500 because this is in inflation-adjusted dollars, with re-invested dividends.  The trend is important.  The values are somewhat arbitrary.)

Here is a chart of the fitted wave.  This only uses 1900-1999 data, so the last 20 years are out of sample, yet still seem to be following the trend.  Of course there are lots of technical theories about predictable movements in asset prices, most of which are questionable.  There could be a reasonable explanation here, though, having to due with baby boomer types of generational fluctuations, for instance, which might create long-term shifts in real growth rates that are difficult to arbitrage because they literally cross generations.

Anyway, for what it's worth, the sine curve fluctuates from annual total real gains of about zero to about 10%, and we are currently right at the peak, where expected annual returns would be about 10%.  Make of that what you will, if anything.

There is still a standard deviation of close to 30% in the difference between market prices and the fitted curve, but if that means that in, say, 5 years, equity holdings after reinvested dividends would be expected to be worth around 15% to 75% more than they are today, that seems reasonably better than if (using a linear trend line instead) they were only expected to be worth 0% to 60% more.  With equities, it is still the holding period that should dominate one's allocation, because short term noise is the key risk factor.  But, this seems like something to consider on the margins.

Friday, January 3, 2020

December 2019 Yield Curve Update

The yield curve continues to press upward from the mid-year lows.  This is mildly bullish, but I would still say that the yield curve is in bearish, inverted territory (below the trendline in the second chart).  We may sit here for a while (several months?), but my guess is, per past patterns, that either 10 year yields will move up above 3%, and the Fed will keep the target rate low, and we might escape a contraction, or 10 year yields will remain close to where they are, and eventually the entire yield curve will move back down toward zero, and we will have some sort of contraction.  I don't think the contraction would be extreme, and it may not even bring much of a decline in equity markets.  The ingredients that made 2008 so disruptive aren't in place today.  The Fed appears to be ready to react to contraction without as much delay as they allowed in 2006-2008.  And, though perma-bears will always be with us, as are the poor (in the long run, maybe they are one and the same!), I don't get the sense that the same suicide cult mentality is so strongly shared as it was in 2008, when Americans would only be satisfied with some sort of financial meltdown.

So, in short, this month doesn't change my posture much.  I think the odds are greater than 50% that future near term yields will be lower than current forward yields, maybe a slight rise in unemployment and decline in equities if the inverted yield curve, as I see it, does signal some coming contraction, and housing that will probably look a lot like 1999-2001, at worst seeing a slight pause in growth.

Thursday, December 19, 2019

Housing supply isn't constrained in Phoenix

Scott Sumner has a post over at econlog today about the mystery of low housing starts.
But what if supply is also constrained in Phoenix and Las Vegas?  I don’t have any good explanation for what that might be so, but the data strongly suggests that there is some sort of supply problem.  The high prices are back, but construction remains severely depressed......I have no idea why supply in these markets is so constrained.  I’ve read articles that make vague references to the cost of land and labor, but no real explanation of why things are so different from 2003.
As Scott frequently points out, bubbles are not nearly as numerous as they are made out to be.  It is important to remember that what happened in cities like Phoenix in 2005 was an extreme anomaly.  A combination of population flows and capital flows that briefly pushed both the demand for real shelter and the funding available for it high enough that the local short run supply curve became disruptively inelastic.

In most cities at most times, where demand hasn't pressed quantity demanded so far up the supply curve that it becomes inelastic, changing demand only has minor effects on price.  When markets are relatively normal and supply isn't extremely inelastic, changing demand mostly affects quantity.  Even in 2006 and 2007, housing starts underwent extreme fluctuations before prices followed them down.  So, the signal in Phoenix is a reasonable reflection of changing demand.  (There was another anomaly in housing, after the crisis, where severe limits to lending pushed prices down in many cities.  That, again, though, was an extreme anomaly.  As Scott shows in his post, slowly this anomaly has reversed, also.  So, Phoenix was subjected to two anomalous housing events.  An extreme upswing in prices - what you might call a bubble - followed by an extreme downswing in prices that was also far from a level that long term fundamentals would justify.)

You can see this in population and migration data.  One effect of extremely tight lending that has prevented aspirational middle class homeownership since the crisis is that population and migration trends that had been steady since WW II into places like Phoenix have been sharply curtailed.  Migration briefly declined to nothing in Phoenix for a few years after the crisis, and has since recovered to a level where the difference between Phoenix population growth and US population growth is only about half what it was pre-crisis.

Phoenix builders could build thousands more homes each year without much rise in cost.  Actually, prices in the low tier existing housing stock in Phoenix probably need to rise a little bit more to make building profitable.  This is a sign that lending regulations are the key variable moderating demand.  Building rates are highly correlated with income and with home prices, both within and between metro areas.  Low tier demand is in retreat because it has been pressed into a landlord's market.  This shows up both as a decline in inter-metro migration and in a retreat of real housing consumption combined with high rent inflation in low tier and rental markets.  The FHFA and CFPB's have-nots are either stuck in place or in retreat.  This also shows up in American Housing Survey data that suggest household size has continued to slowly decline among homeowners but has reversed and started to climb for renters, since the crisis.

What about the issue of costs?  I suspect there is something to that.  Low interest rates do make land more expensive. (Back yards are much more rare in the new neighborhoods in Phoenix than they used to be.)  Regulations, etc. have all probably risen somewhat since the crisis.  So, low tier prices might need to rise even more than they would have needed to without those issues.  But these are marginal changes that can't be responsible for such universal and extreme shifts in building rates around the country.

On the topic of labor costs, however, I think there is something interesting here.  Here is a graph of construction employment in Phoenix as a percentage of total employment.  This did briefly rise during the boom, and then collapsed to very low levels after the crisis.  This is especially striking if you believe, as I do, that Phoenix never had an oversupply of homes, only a sharp negative demand shock, which is clear in the population chart above.  (I think the 2010 dip is probably due to a data revision, which is likely due to population growth that was lower in 2008 and 2009 than shown.)

Economists such as Peter Boettke and Arnold Kling talk about the economy as a coordination problem.  I think this is a valuable and useful way to think about the economy.  The problem here is that this extreme disemployment in construction has been universally accepted as something that was necessary.  Economists have treated the collapse in construction employment as the necessary correction that had to take place, and blamed the slow recovery on the scale of that correction.  But, what if that wasn't a correction at all?  What if that was the disequilibrium.  Consider the scale of the damage we have imposed on our own economy through monetary and credit strangulation that we were able to permanently disassociate 3-4% of the Phoenix labor force from a reasonable and useful local industry.  This damage has been so diligently imposed that the dislocation remains in place a decade later and these workers have disappeared.  Builders complain of a labor shortage.  What happened to them?  Did they give up? Did they move away?  Did they have to go through a difficult (and unnecessary) transition to other work?

Hysteresis has been an idea sometimes used to explain the slow recovery.  Here's your hysteresis.  Even today, I commonly see people react to slow housing starts by asking, "Aren't we still working off the oversupply of the bubble?"  That is absurd.  It was absurd when Bernanke asserted it in 2011.  It was absurd in 2005, frankly, though one can certainly understand how conventional wisdom got it wrong at the time.  The fact that this idea is still floating around the zeitgeist in 2019 is a signal of how misguided conventional wisdom has been about housing.  The persistent unemployment of those workers was a policy goal shared by both populists and technocrats.

Wednesday, December 18, 2019

A nice review of "Shut Out" at CATO

David Henderson, one of the frequent posters over at econlog, who I have always enjoyed following, has a very nice review of "Shut Out" at Cato.  It begins:
In his recent book Shut Out, Kevin Erdmann, a finance expert and visiting fellow at the Mercatus Center at George Mason University, has two main messages. The first, which is not controversial among economists, is that restrictions on residential construction in coastal California and the urban Northeast have constrained supply so much that housing in those areas is virtually unaffordable for people in the lower- and middle-income classes. His other message is more controversial: the financial crisis last decade was not due to a housing bubble but, rather, to bad policy decisions based on the idea that there had been a bubble. Whereas I was already convinced of his first point, I, like the majority of economists, was skeptical of his second. But because of all the data and reasoning he brings to the issue, I now find myself at least 90% convinced.
Please click on the link (pdf) for the rest.

I need to get that darn second book finished to address the other 10%.

Tuesday, December 17, 2019

The Divergence in Incomes and in Resource Usage

Recently, I was listening to Russ Roberts at EconTalk interview Andrew McAfee.  The topic was the surprising change in trends in resource use.  It appears that as economies grow, at first resource use increases, but eventually economic growth comes from more efficient use of resources instead of through the brute force of added resources.  Surprisingly, the use of many resources has been declining for some time in the developed world.  Not just in per capita terms, but in total.  Now, getting richer seems to mean using less.

They mentioned that the divergence seemed to happen around 1970.  Here is a graph of real GDP growth, iron and steel, and cement use, all indexed to 1970, using data from McAfee's website.

Although I don't think they mentioned the parallel in the program, I immediately thought of this graph that is frequently cited in the income inequality debate.  The source of this graph has made it quite clear what they think caused the divergence.
It seems likely to me that these issues are linked.  As economic growth became decoupled from the Malthusian quest for more resources, it became associated with rising services and status competition.  There could be a number of things going on here.  First, if it is easier to meet basic physical needs, there may be less motivation to increase income above a certain threshold.  Also, the real economic value of services and status items may be more difficult to track because it isn't based on the blunt measure of a physical quantity of inputs.  Variable inflation rates may be more difficult to track.  Think of the difference in rent between San Francisco and Little Rock, or groceries at Whole Foods vs. Wal-Mart.  Or, the price of a last-minute business class airplane ticket vs. an economy ticket.  Or, the vast number of services created by the internet that are commonly provided for free.  Think of the cost of Bloomberg financial services vs. the huge amount of data sites like Zillow make available for free.  The value of things versus the price of things has become highly variable.

In any event, these developments seem certainly to be related, and the transition away from a resource based economy seems like a much more relevant trigger than President Reagan.  I suspect there is a combination of mismeasured well-being and variance in well-being that is largely played out in status seeking services.  Thus, measured inequality seems high even though most households can purchase basic goods at real costs that are far below what they were in 1970.

I wonder if those who give Reagan such an important role in relative measured income growth after 1980 would feel such a strong intuition about the first graph, and hail Reagan as the president who curtailed resource usage.

Monday, December 16, 2019

An interview with ALEC

I really appreciated being allowed to share my work with ALEC at their recent conference in Phoenix.  I saw a lot of great nuts and bolts activity going on there in the service of creating an equitable and economically vibrant nation.

Here is a short interview from the conference.

Friday, December 13, 2019

November 2019 CPI inflation

Inflation remains in a holding pattern - about 2.3% core inflation, which consists of 3.3% shelter inflation and 1.6% non-shelter core inflation.

The yield curve is, similarly, in a holding pattern.  How this plays out will depend on unanticipated real shocks over time and the future bias of the Federal Reserve.  My inclination is to continue to believe the short term outcome will mostly accrue to declining Treasury yields and the depth of that decline will greatly depend on the willingness of the Federal Reserve to support short term NGDP growth.  The slow moving train wreck (or not) continues.  As long as non-shelter core inflation remains below target and the yield curve remains effectively inverted, my expectations will be somewhat bearish.

Wednesday, December 11, 2019

Momentum in equities when reputational risks are high

This blog originally was supposed to mostly be about investing tactics, but I got sidetracked when I discovered the housing issue that has ended up taking over.

Here is a post on the topic I used to dwell on - tactical investing for high returns by being insensitive to reputational risk. A recent example of this issue is Hovnanian Enterprises, a major homebuilder that is still so down on its luck as a result of the housing bust that as recently as July, it was being threatened with delisting from the NYSE.

All along, they have mostly just needed the market in new housing to recover.  They need revenue to fully regrow back into the financial and organizational framework that had developed under the Hovnanian name in 2005.  They have so much organizational and financial leverage that small increases in revenue will translate into large increases in market capitalization.  This will further be enhanced by knock-on effects of recapturing the value of tax assets and written down developments, and paying or refinancing debt at more favorable terms.

After the July delisting notice, Hovnanian released results of two quarters which have provided strong evidence that revenues will be growing and these positive developments will be coming.  Normally, efficient markets would internalize these developments immediately, and a firm's share price would immediately jump to a level reflecting the new expectations.  Financial research has shown a momentum effect.  In other words, a trend in share prices doesn't happen 100% at once.  It mostly happens at once, but there does appear to be some predictable serial correlation.  A recent trend shift or a recent positive or negative shock to a share price will tend to continue in the short term, to a certain extent.

But, in unusual positions where reputational risk has become acute, this momentum effect can become very large.  I am sure there were some institutional holders who were forced by their own rules to unload shares when Hovnanian received the delisting notice.  At some point, the reputational danger of having owned a stock or of recommending a stock, can overwhelm the objective value of it.  In these cases, the market for that equity becomes very tepid.  It's sort of like very thirsty wildebeests coming upon an oasis.  They very understandably approach it carefully at first, not sure if it is safe.  But, almost inevitably, the whole herd will be lined up at the shore, sucking up water vigorously.  To someone who happens to have been at that oasis when the herd showed up and recognizes already that there are no crocodiles, this process can seem excruciatingly slow.

Here is the Hovnanian stock chart from the past 6 months.  The positive shocks are noticeable after each quarterly announcement, but even those shocks took place over several days.  Following the initial quarterly shock, there was further upward drift for some time.  The more recent positive shock also took several days to play out.  It will be interesting to see if a positive drift follows this shock also.  If revenues do climb from here, the share value is likely many times the current market value.  Getting from here to there will reflect a combination of objective results, expectations, and changing reputational risks.  It is the implicit position on reputational risks that can provide very high returns over time, but it comes with the occasional risk of losses, and those losses will necessarily be devastating and embarrassing.