Equity Values and Business Cycles

This chart is basically a "Financial Accounts of the US" version of the P/E ratio.  Also, here I show corporate debt as a ratio with corporate profit.

Source

These are as of the 3rd quarter of 2018.  After the recent pullback in equities, while earnings are strong, the P/E ratio (blue) is back to the teens.  And, corporate leverage is in a conservative range too.

Going forward it seems that there are two likely paths:

1) Stable NGDP growth leads to slightly lower profit growth, but higher wage growth and higher real total growth.

2) Unstable NGDP growth leads to lower profits and wages.

If (2) happens, equity losses will be widely blamed on valuations and debt even though they will more likely be caused by unstable NGDP growth.  In hindsight, it will always look like high valuations caused equity contractions and high debt levels, because equity prices will be lower and vulnerable firms will suddenly be too leveraged.  But cyclical contractions rarely have anything to do with valuations or corporate debt.

Housing: Part 341 - Arbitrary categories should not determine sentiment and policy

Housing can be consumed in three basic ways:

1) Tenancy

The capital is provided by an investor.  The investor takes the risk of changing value and the responsibility for maintenance.  The tenant pays for the service of shelter in the form of a cash payment.

2) Mortgaged Ownership

The capital is provided by an investor.  The tenant takes the risk of changing value and the responsibility for maintenance.  The tenant makes a fixed payment to the investor for the use of her capital.  The tenant does not make a cash payment for the service of shelter, because the tenant is also the owner.

3) Free and clear Ownership

The capital is provided by the tenant.  The tenant takes the risk of changing value and the responsibility for maintenance.  The tenant used her own capital, so she makes neither a fixed payment to an investor nor a cash payment for rent.


The production and consumption of shelter is basically the same in all three scenarios.  There is simply a shift between who plays the various roles.  In the first scenario, we say that the investor is providing landlord services to the tenant.  In the second scenario, we say that the investor is providing financial services to the tenant.  In the third scenario, we say (or at least the BEA says) that the investor is earning "rental income of persons".

But really, we're just shuffling around a group of agents who, together, are providing capital for shelter, maintaining the shelter, and consuming the shelter over time.  The way they are shuffled has little bearing on the aggregate amount of capital and the aggregate value of the shelter.  Yet the way we think about each different scenario and the way it affects public policy is tremendous.

In this graph, the top line is the total value of shelter consumed, as a percentage of GDP.  It is pretty stable over long periods of time.  During the 1960s and 1970s, it was 8-9% of GDP.  During the 1990s and 2000s, it was about 10%.  Since the crisis, it has run at more like 11%.  (Clearly, this isn't because we have created more shelter since the crisis.  This is because demand for shelter can be inelastic.  Rent inflation has been high because we are not producing enough new housing, so we are spending more for less.)  All that being said, this is consumption that is stable over quite long periods of time.

In the graph, the next line down is gross value added - the cost of housing before maintenance and upkeep.

The next line down is operating surplus - the net income to the agents providing the capital in each scenario after subtracting maintenance and upkeep, consumption of capital (basically natural depreciation), taxes, and subsidies.

Finally, the red line is the portion of the housing capital income that goes to the investor in scenario 2.  This is actually a bit misleading, because the operating surplus is real income.  It increases over time with inflation.  Interest income includes a premium for expected inflation that is paid in cash over time and appears as financial income when it really is not.

That last red line, then, is a fairly arbitrary measure, both because it doesn't even measure real income and because it is only one type of income from one of the three scenarios of ownership.  But, it is the scenario that is labelled "financial", and it gathers more attention than any of those other, stable, less arbitrary measures.

During the housing bubble, the expansion of the housing stock was allowing households to moderate their housing consumption by moving to cities where the capital providers don't capture economic rents from political oligopolistic power over real estate.  So, the operating surplus to housing (which is the non-arbitrary measure of housing income) was declining.  But, the arbitrary measure got all the attention.

Maintaining lower interest rates that weren't contractionary would have kept the red line low, and possibly would have kept net operating surplus moving lower.  Since then, there has continued to be a lot of focus on the arbitrary red line, and a lot of happiness about how much lower it has moved.  At the same time, the non-arbitrary measure of income to housing has moved up (because of a lack of supply, which is ironically related to that declining arbitrary red line) to a level not seen since the early days of the Great Depression.

By railing against "financialization" and "Wall Street" profits, we have managed to shovel more income into the hands of oligopolists than any housing bubble ever could have.

Housing: Part 339 - Self-Imposed Stagnation

Here is a graph comparing long term real GDP growth per capita and per worker.  Also, I show the 10 year trailing average annual real total return on the S&P500.

Real GDP per capita had been rising by about 2% for many years.  Real GDP per worker generally rises at about the same rate, but in the 1970s, it dipped down to less than 1%.  This is because the baby boomers were entering the workforce, so the labor force was increasing faster than population was, and we weren't getting as much productivity growth per worker as we had previously.  Some of this might just be a product of worker composition and young workers being less productive.  But, I think this shows why the 70s were a decade of economic insecurity even though it doesn't necessarily show up in real GDP growth or even real GDP growth per capita.

One plausible reason that equity risk premiums have been high recently and real bond yields low is that an aging population means that there are many households in the saving phase of their lives.  But, that doesn't explain the 1970s when real bond yields were also low.  In the 1970s, there was a surge of young adults.

Notice in this graph that total returns in equities seems to track pretty well with GDP growth per worker.  Since investor expectations can't be measured it has become widely accepted that even long term stock market movements are the product of fickle sentiment and that stock market returns are more volatile than changing economic growth rates because of that fickle sentiment.  Relationships like this suggest that sentiment isn't as fickle as it has been claimed to be.

There also seems to be a widely held belief that the US stock market is overvalued because of loose monetary policy.  To the extent that that sentiment affects public policy, and I think clearly it has, it is probably one reason why real growth has been so slow.  I'd like to stake out the principle that in order to propose the goal that the central bank should aim to lower real returns for existing shareholders, your model of how the world works should be at a level of confidence that is practically certain in a way that few economic models have ever been.

In my Upside Down CAPM model of thinking about capital markets, expected real total returns are fairly stable, at about 7% annually.  This is a combination of expected growth and current income.  When growth expectations decline, savers become risk averse.  So, two things happen to equity returns.  First, the equity risk premium (the difference between Treasury yields and equity returns) widens because safe-seeking investors are willing to accept lower returns while total expected returns on at-risk capital like equity remains relatively level.  Second, the growth portion of expected returns declines, which means that the income portion increases.

Recently and in the 70s and 80s, payout rates were high (dividends + buybacks) and in the 90s they were lower.  Generally, payouts are referred to as a bottom up phenomenon, as if firms can't find good investments, so they send the cash back to investors.  I think this is more appropriately viewed as a product of low growth, so that there may be some correlation between high payouts and low growth, but that it is more directly a product of low growth because equity investors require more cash flow in their total returns to make up for the lack of capital gains growth they expect.

The changes in real returns over time are related to the changes in GDP per worker, due to both the real shock of lower productivity and lower expectations that will naturally come along with that.  Those past equity investors, on the margin, expected returns of around 7% plus inflation, and where their realized returns differed from that, it was due to changing profits and changing expectations from those unforeseen changes in real production.

This is all a long-winded way of getting to the point I want to make, which is about the current decline in growth.  Here is a similar graph, but here I am comparing GDP growth per worker and per capita to the percentage of GDP going to residential investment, because that is the main reason for the recent decline.


Before the financial crisis, there was little relationship between Residential investment and GDP growth.  Some of the short-term growth in the 2000s before the crisis might have been related to it.  But, as I tend to point out, that was at least as much a product of building in the 1990s being below long term norms than it was a product of excessive building in the 2000s.  The low ten year moving average in 1999 was unprecedented in post-WW II data.  The high ten year average in 2007 was not.  So, maybe a lot of the rise in per capita GDP growth from just under 2% to somewhat above 2% was from homebuilding.  But it was homebuilding production that was reasonable and sustainable.

But, what I want to talk about is the post-crisis decline.  That decline can clearly largely be attributed to collapsing residential homebuilding.  GDP growth per capita declined from about 2% to about 1%, and residential investment declined by 2% of GDP.

I like Arnold Kling's conception of patterns of sustainable specialization and trade.  It is better to think of an economy as a coordination problem with frictions rather than as a set of accounting identities.  And, I think it would be uncontroversial in any audience to suggest that this is a large part of what happened after the crisis.  There were millions of construction affiliated workers after the crisis that faced frictions in finding work in a different sector.  Possibly, the recent uptick in per-worker GDP growth, the recent low levels of unemployment, and anecdotal claims that construction workers are hard to come by, are signs that those adjustments have finally been made.

My disagreement with the consensus on this is that none of that had to happen.  For the past decade, those workers should have been engaged in building homes, and GDP growth per capita should have been 2% instead of 1%.  Not only would that have meant that none of those painful adjustments needed to happen.  But, it also would have meant that we would have about $2 trillion worth of housing providing the service of shelter for American households.  And, the result would have been that American households would be shoveling a few hundred billion dollars less each year of unearned rental income to real estate owners.  (Of course, this is complicated by the fact that many of those real estate owners are homeowners, who can only capture that "income" by staying in a home that has inflated rental value, but a suppressed market price, so they can't actually realize the gains from their economic rents except by living in a home that has rental value higher than it should have to begin with.  But, this is getting too far down the rabbit hole.)

But, here we are, a decade later, and maybe most of those former construction workers have either moved to other sectors or just dropped permanently out of the labor force.  So, then, what do we do about the housing shortage?

Well, I have written some about the inequities in the way we have contracted the housing market, and I expect to write some more.  But, really, in the end, there is nothing unsustainable about this context.  We could have achieved similar ends by raising property taxes, or any number of things.  All consumption has some foundation of technological, tax, and regulatory factors that has an effect on supply and demand.  Just because our current context seems inequitable to me, that doesn't mean it can't exist as it is.  Non-owners will consume less housing, owners will consume more, and real estate investors will earn higher returns than I think they would in my preferred regime.  But, it's a sustainable regime.

So, the "economy" doesn't need housing to recover.  It could be that we now are at a new pattern of sustainable specialization and trade, and the new pattern just includes less consumption of shelter by the have-nots.  The workers that have been on the sidelines for a decade instead of building homes have slowly found other productive things to do.  So, fixing the housing shortage is more about equity than it is about growth.  It is possible that we have finally entered a new phase of growth, that ten years from now, GDP per worker will have risen by 20% and equity investors will have earned 12% annually plus inflation, that working class families will be moving to Sacramento by the thousands so that young entrepreneurs can rent their old studio apartments in San Francisco for $7,000 a month, and that marginal workers will still be paying $1,000 rent to live in homes in Cleveland that they could buy for $60,000 because we have decided as a public policy objective that it is too dangerous for them to have a mortgage.

Every line in those graphs could move back toward the top while the residential investment line stays at the bottom.  We would just live in an economy where some households don't consume housing like we did in the past, and real estate capital earns slightly higher returns.

PS: Since equities aren't as tied to domestic production as they used to be, it could be that the rate of real total return on equities will be less volatile going forward as a function of changing domestic productivity.  So, it could be that equity returns for the S&P 500 over the past ten years are higher than they would have been 40 years ago, given the same slow rate of GDP growth per worker, and that it won't rise as high as it used to with rising US productivity.

Housing: Part 321 - What about those naive bubble investors?

There is a story from "The Big Short" where a stripper in Las Vegas explains that she has several highly leveraged investment properties.  This is also a response I have heard and that I see frequently when people take umbrage with my assertions about the housing boom.  "Look, this is all very interesting, but I remember what it was like back then.  The janitor at my office had 7 properties.  It was nuts."  This is especially true of Phoenix and Las Vegas.

This a great example of how some basic factual truths can completely turn your conclusions upside down with just some subtle changes in interpretation.

These people existed - in some significant number.  But, let's think about this.  The housing stock is a big, slow-moving beast.  It doesn't change by more than a few percentage points a year, at most, in a fast growing city.  If you know, say, 4 people that have purchased 5 homes as speculators in the past couple of years, then you should also know about 20 people who have sold homes.  Every home has one owner and every transaction has a buyer and a seller.  So, if you say that you suddenly knew 4 people that each owned 5 speculative properties, then that is basically the same statement as saying you knew 20 people that had sold out of the real estate market.  Two sides of the same coin.

Outside of extreme circumstances, if you know four people that are deep into property speculation and you don't know 20 people who have sold out of properties, then you have stumbled into a deep case of observer's bias.

It happens that in 2006, there were extreme circumstances.  In 2005, annual population growth in Phoenix was over 3% and it was over 4% in Las Vegas.  Between 2005 and 2009, it fell to less than 1% in both cities - a rate of growth slower than either city had seen in decades.  This was a combination of more people moving away and fewer people moving in.  Builders were actually pretty sensitive to this shift, and permits for new construction fell sharply along with population growth.  But, in addition to those migration shifts, tens of thousands of potential new home buyers had entered into contracts to build new homes, and upon seeing the turn in the market, they reneged.  They let the builders keep their small escrow deposits, and they left those homes with the builders.  There was a massive shadow inventory of homes left to builders long before owners were defaulting and leaving homes with the banks.

So, if you knew 4 people who owned 5 homes, you came upon your observer's bias honestly.  Those 20 housing shorts weren't in your frame of vision.  They had either left town or had never moved to town. When you were sitting at the barber shop listening to the guy talking about the seven condos he was flipping, the seven housing shorts that were an integral part of that story were getting their hair cut in LA and Chicago.

This is one reason why migration is such an important corrective to our conception of what happened.

Note that the truth is even there in the conventional telling of the story.  In the scene in The Big Short, when the stripper tells Mark Baum that she has six leveraged properties, he warns her, "Well, prices have leveled off, though."  The trigger for expanding investor share was the negative change in sentiment among homeowners, and the leveling off of prices in the Closed Access cities which reduced the rate of tactical Closed Access sellers.  That scene immediately cuts from the strip club to him making a phone call and saying, "Hey, there's a bubble."  What he had actually just seen  was evidence of the bust, not a bubble.

Were many of those new speculators naïve?  Were they late to the party?  Could we bemoan their lack of judgment?  Sure.  Can we blame them for high prices?  No.  Investor buying was somewhat elevated in 2005.  Maybe it could have added a few percentage points to the average home price at the peak.  Investor buying share was highest in 2006-2007 when prices were stable - and investor buying was, by then, a stabilizing influence on prices.  Investor share declined in 2008 and 2009, and during that period, investor defaults were probably also destabilizing, because investors are quicker to default in declining markets than homeowners are.  Then, investor activity settled in at levels in 2010 that were still above 2004 levels, again providing support in markets where homeowners were now credit constrained.

It's possible to dissect the different types of investors and speculators and to point out where there were more reckless or even fraudulent speculators, which appears mostly to involve investors who claimed to be homeowners, which would cause lenders to underestimate their tendency to default on high LTV loans during a crash.  And it is possible to point to some brief points in the timeline where those investors may have been a bullish force in markets that were rising already.  But, their activity just can't be pushed back far enough in the timeline of events to attribute much of the aggregate national value of real estate to them.

Through the main characters in The Big Short, we can see how easily this can lead public sentiment astray.  There were many people who had been calling the market a bubble for years by 2006.  They identified themselves as people who new the value of things and who could be more wise than the average investor about avoiding poor investments.  That's a great identity to have, and for the main characters in The Big Short, it appears to be plausibly accurate.  But, it is just a short step from that to a posture of attribution error - I do things because of the constraints I face, but other people do things because they are greedy or reckless.  Multiply that by a few million people who sit down and watch The Big Short, and think, subconsciously, "I know value.  I identify with these characters.  We all recognize the greed and recklessness of all those background characters, which created the bubble."

That sentiment was part of a positive feedback loop that led to widespread blame on speculating and lending, and that blame only strengthened with each year of rising prices.  So, when migration stopped and these investors and speculators became a noticeable part of the market, it didn't look like a sentiment shift.  It looked like more of the same.  More of those other people acting on greed and recklessness.  And, the tricky part is, many of them were acting on greed and recklessness.  But, that doesn't change the fact that they didn't cause the bubble and that, in reality, they were a red flag signaling a coming crisis.

Instead of clamping down on credit and money growth, we should have been aiming for stability.  We should have been adding nominal support for these markets that were about to be hit with a migration whiplash.  What about moral hazard, you ask?  I suppose that if we had done that, some of this "dumb money" would have been somewhat better off (although, even a moderately accommodative credit market and monetary policy at the time would not have been likely to reignite the migration event.  Las Vegas and Phoenix would have likely still seen some price retraction.)  But, there is no benefit to punishing the "dumb money".  "Dumb money" didn't cause the bubble.  The bubble drew in "dumb money".  Hurting those late-cycle speculators did nothing to prevent a future bubble.

It seems to most people like it would, because those late speculators just seem like one more fish in a school that includes Alt-A homeowners in San Francisco in 2004, Fannie and Freddie borrowers in 2002, and new young first-time buyers in 1999.  Moral hazard is not why the median home in Los Angeles was selling for over $600,000 in 2006, though.  In fact, it is the opposite.  Prices in LA were that high because anyone who wants to build some housing units must first spend the better part of a decade addressing every single possible objection to building housing units.

Housing: Part 300 - The Global Bubble Hypnosis is a Larger Problem than NIMBYs

Here is a recent article at the Financial Times.  The headline:

New York property jitters herald declines elsewhere

 The first line:

Clouds are hovering over New York’s housing market.

This is a great example of the mass hypnosis that has infected the public consensus on housing.

There is a broadening realization that the lack of access to urban labor markets and the lack of access to affordable urban housing are the prime challenge of early 21st century economics.  The problem is, solving that problem requires economic dislocation and upheaval of urban housing markets.  If you see falling real estate prices in urban centers should your reaction be to worry about "clouds hovering" over urban real estate markets?  I say, celebrate.

If our primary economic problem is that a lack of housing in urban centers causes it to be overpriced by a factor of 2 or more, then the DIRECT solution to that problem is that urban real estate needs to lose 50% or more of its value.  This article begins by noting that the median price per square foot in New York City has declined by 18% from last year.  Your reaction to that should be, "That's a great start!"  Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

Further, the article argues that global capital markets are leading to a new synchronization of urban real estate markets, so that additional supply is such a strong factor in bringing down urban housing costs that new units in New York City can bring down prices in London.  Your reaction to that should be, "Wonderful news!  Supply is a much more powerful factor than we thought."  Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

Reasons given in the article for this drop in New York prices include: (1) removal of tax benefits, (2) "glut" of luxury supply, (3) globalization, (4) "financialization", (5) "ultra-loose" money.  Your reaction to that should be, "Oh.  OK.  Those must all be good things.  Let's do more of those things."   Full stop.  If that's not your reaction, then what are you doing?  What's your purpose?

But, that's not the direction the article takes.  The article notes that sales volume is also down, and, as is the convention, it treats this downturn as the inevitable end of a boom bust cycle.  So, instead of seeing the drop in sales as a sign that all these good things might come to an end - as something we should counter - the article treats the boom that preceded it as the problem, and the solutions proposed are all policies aimed at stopping the real estate expansion before it develops!

This is an explicit defense of a monetary and credit regime that is specified to ensure rising urban real estate costs.

Now, admittedly the problem of solving urban costs is difficult, because normalized, unconstrained urban housing markets would require building with few unnecessary obstructions and low costs.  And, part of what happens in these regimes is that the bridge between basic costs and market value gets filled with all sorts of "limited access" rent seeking.  Developer fees, concessions to advocacy and neighborhood groups and municipal powers, queuing, etc.  These added costs emerged.  They didn't develop as some sort of plan.  So, if supply actually starts to increase enough to bring rents down to a reasonable level, these extra costs will have to be reduced in order to allow new development to come online profitably. Since the cost of queuing is pure waste, the first step here is "easy".  Just keep pushing through more projects for approval that are bringing in those "clouds".  There are a few trillion reasons why local planning boards aren't going to do that to existing owners and developers.

But, for activists and researchers who want to solve the urban housing problem and for global financial journalists who cover these markets, the reaction to that political problem should not be to kill any booms in their infancy.  The reaction should be, "How do we entice these urban planning departments to keep pushing through new supply when it looks like a downturn is coming?"  Because, to refer to any supply in these cities as anywhere close to a "glut" is a laugh.  A horrible, dark, depressing laugh.  There will be a glut of supply when rent in New York City is similar to rent in Atlanta, or even Chicago.  Until then, any use of the word "glut" to describe New York City housing should be met with laughter.

The reason we are engaged in this odd public rhetorical house of mirrors is because we all have a virus in our brain.  It's a cultural meme.  And it's a received canonical premise that there was a housing bubble, and that bubble was caused by loose money and loose credit.

The housing bubble, such that it was, was caused by an extreme shortage of urban supply.  Because of that shortage of supply, the process of meeting the public need for housing requires a "bubble" and the availability of credit that is flexible enough to allow for ownership where rents regularly take 50% or more of a household's budget.  Since supply in those cities barely responds to price, prices in those cities have to be bid up to high enough levels to induce outmigration so that new housing can be built in the rest of the country where supply can react to high prices and high demand.  At the peak of the US housing "bubble", credit markets were just beginning to push market prices to a level that induced that new supply.

Now, it would be better to build ample units in the urban centers.  But, since that doesn't appear to be close to happening, this was a second-best solution.  And, in terms of rent - which is the appropriate measure for considering housing affordability - 2005, briefly, was the one point since 1995 where supply at the national level was abundant enough to moderate rising rents.

Unfortunately, the Closed Access cities in the US are such a problem that in order to create enough housing at the national level, we had to induce a mass migration event out of those cities, and that mass migration event was the source of the dislocations in places like Phoenix that drove the country to demand a credit and monetary contraction.

This is the first step to fixing the problem.  We need to get that virus out of our heads.  The problem, all along, was supply.  Trying to pop the bubble before it inflates is the opposite of what we need to do.  I think the first rhetorical step to beat this virus is to stop thinking about housing affordability and housing markets in terms of price.  Price is a secondary function.  Affordability is about rent.  And, in the end, price is also about rent.  And, in the past 25 years, there have been two successful means for moderating rents.  (1) build like it's 2005, or (2) pull back on the money supply and credit so severely that a good portion of the country is foreclosed upon.

If we had committed to (1), today rents would be lower, prices would be higher, homeownership would be strong, and American balance sheets would be healthy.  It would be nice if a lot more of those American households could also live in the coastal cities.  I don't know if that can happen, but it sure as heck isn't going to happen if there is a consensus reaction to protect those precious urban real estate values every time the solution actually starts to play out by worrying about a "glut" of supply, and then by accepting pro-cyclical credit and monetary policies in order to "pop" the "bubble".

In that counterfactual, where the urban supply problem isn't solved and the rest of us commit to abundant supply, there would be gnashing of teeth about how the Federal Reserve is feeding bubbles and they are at fault for making home prices too high.  We have indulged that intuition for a decade now.  Now we know how wrong that is.  This was the darkest timeline.  Let's roll the dice again and proceed with the knowledge that doing it wrong has provided us.

New York real estate is getting cheaper and is pulling housing costs down in other cities, says the Financial Times, because (1) removal of tax benefits, (2) "glut" of luxury supply, (3) globalization, (4) "financialization", (5) "ultra-loose" money.  OK.  Those must all be good things.  Let's do more of those things.  What's your purpose?

Wage pressure is not inflationary.

The employment cost index for the first quarter continues to show some moderate strength.  This has led to new discussion about inflation, etc.

I have written a few posts about the Phillips Curve - the idea that wage growth and inflation are related, or that rising wages lead to rising inflation.  I don't think this relationship works the way it is generally described.  Monetary inflation should certainly cause wages to rise just as it should cause all price levels to rise.  Clearly there is causation going in that direction.  I think the apparent causation going in the other direction is misleading.  It is a matter of only feeling parts of the elephant.

One main piece of evidence that makes it look like rising wages lead to inflation is that firms report tight profit margins that are being squeezed by rising wages.  They either have to raise prices or reduce profits.  It seems likely that this would produce price pressure.  The idea of cost-push inflation is alluring, but not useful.

First, there are two potential sources of wage pressure.

1) Rising capacity utilization.

2) Fundamental productivity growth.

On point 1, as unemployed workers return to the labor force and the pool of potential workers declines, there are pressures on wages.  But, an economy running below capacity is not a productive economy.  In this context, both wages and profits should rise, but this should be more than compensated for by the boost in productivity caused by utilizing productive capacity.  Wage and profit growth should be real, in this context.  If anything, this sort of growth should be disinflationary as real growth would be strong.

On point 2, it is difficult to grasp in real time the full complement of mechanisms that are in play.  And, we will be more likely to see ailing, dying industries that we are familiar with than new, disruptive industries that are the source of new productivity.  Here, also, it will appear that rising wages are inflationary, but they are not.

Here, it might be useful to think of Amazon vs. brick and mortar book stores.  Wage growth was strong in the late 1990s, and it would have been tempting to look at rising wages at brick and mortar book stores, and to forecast inflation.  That is because those were mature businesses, so they had a very stable and understandable cost structure.  Wages were rising, and they either had to raise prices or lose profits.

But, what we were seeing there wasn't price pressure.  What we were seeing was productive transformation in an economy.  What we were seeing was the end of a business model that wasn't profitable any more.  When any business model comes to the end of its life because of new innovation and productivity, it will look like it is suffering from cost pressures.   But, to the extent that those cost pressures were acute, they simply led to the transformation to new, more productive business models.

Amazon, on the other hand, was hiring like mad.  And, nobody was looking at Amazon as a source of inflationary wages.  That's funny, really.  Because, since Amazon was young, they were not particularly profitable themselves.  But, nobody looks at a young, disruptive company and says, "Oh, labor costs are cutting into their profits, this could lead to inflation."  That's because Amazon wasn't trying to become profitable by cutting costs.  They were trying to become profitable by hiring and growing.

There was a lot of that going on in the late 1990s.  So, profits were low, wages were growing, and inflation was moderating.  And, the stock market didn't seem too put out by the whole state of affairs.

By the way, interest rates were also high at the time, but they weren't high because the Federal Reserve was trying to discipline risk-takers by sucking cash out of the economy.  They were high because investors were risk-takers, and so the safety of fixed income was not highly valued at the time.  The appetite for risk wasn't expressed through borrowing.  It was expressed through Amazon's rising stock price.  It was expressed through expanding equity, not debt.

Rising wages are a sign of progress.  They are something to be encouraged, not tempered.  When wage growth is strong, real interest rates might naturally rise, but there is no reason to try to force them to in order to stop the business cycle.

An unleveraged banking experiment.

I have written previously about my own confusion regarding the issue of bank capital.  The issue seems largely rhetorical to me.  It comes down to whether you call deposits capital, in which case you're an unleveraged money market fund, or you call deposits liabilities, in which case you're a bank.  The difference seems to be that insuring deposits turns them into liabilities.

There are so many debates in finance that seem to me like they could be solved simply.  Too big to fail could be solved by using private deposit insurance instead of public insurance, which would lead to prices that reflect risk.  Even with public insurance, I'm not sure what's stopping us from simply pro-rating insurance fees to reflect changing capital levels or size.  Money market funds seem to do just fine.  To the extent that there is some risk in NAVs falling below $1, it seems to me that a standard contract for investors could have a clause that if NAV ever falls below $1, then withdrawals must pay an additional 1% fee.  This would be a fairly insignificant amount, it would reduce panic withdrawals, and to the extent that there were still withdrawals, they would naturally push NAV back above $1.  In the rare event that this happens, it seems like this would be a stabilizing policy with little cost to investors.

I am sure that I am naïve on these matters and there are good reasons why some of these ideas aren't used.

But, regarding bank deposits, I would like to imagine a system with 100% capital requirements.  Instead of making deposits, depositors would just buy shares in the bank.  The returns depositors earn would not change much, because today depositors make up a very large portion of the capital available to banks, so the returns that currently go to equity holders would be spread pretty thin when shared among the new depositor/shareholders.

But, depositors want certainty.  In this regime, they could get certainty by selling at-the-money puts on their shares.  Depositors would make deposits or withdrawals by buying or selling shares.  The bank would mediate their asset base by buying and selling shares on the open market.  So, sometimes, withdrawers would be selling shares to depositors and sometimes they would be selling to the bank.

This would be a 100% capitalized banking system.  The put sellers would basically be taking the role that today's equity holders take, but with much less volatility because even failed banks usually only have capital shortfalls of a few percentage points of their assets.  In today's system, equity in a failed bank would fall to $0 if the value of assets fell below the value of liabilities.  This system would be more like a money market fund.  A failing bank whose shares had sold at $100 might now sell for $98.  Depositor/shareholders would exercise their puts, and the put sellers would now be shareholders.  The depositor/shareholders wouldn't lose a penny, and they would be free to reinvest their $100 back into the same bank at $98 per share or into another bank.  The main factor determining that decision would be how high the put premium was.  If a lack of confidence led to a run on shares, the bank could recapitalize by buying shares at the market price if that price fell below NAV.  The only losers would be the put sellers.

There could even be a public agency through the Fed that was a major put seller.  This would create a natural method for recapitalizing banks during nominal financial crises, because depositors would buy shares in other banks, and when the Fed funded exercised puts, it would be a natural monetary injection into the system that was automatic and didn't require discretionary decisions about which institutions to support.  Of course, this whole system would work better with some moderate inflation so that share prices tended to have an upward trajectory and exercised puts weren't triggered frequently.

In a way, this wouldn't be much different than today, where the Fed owns a bunch of treasuries and also holds reserves that they pay interest on, and monetary policy comes from managing both of those quantities.  In this system, they would earn income on treasuries they own and on puts they sell, and they would manage the quantities of treasuries and bank shares that they own from exercised puts.  It would sort of be a nationalization of the commercial banking system, because as a put seller, the Fed would basically be taking the risks that current bank shareholders take.

Today, banks are induced to take risks because the upside flows to shareholders.  In this system, that upside would still exist, but it would have to be earned through put premiums as income.  Riskier banks could offer shareholders higher dividends, but it would come with higher put premiums.  Maybe seeing that bank share prices rarely declined by more than a couple percentage points, few depositor/shareholders would even bother buying puts.

Since upside profits would be retained by the depositor/shareholders, put sellers would have less potential upside than today's bank shareholders do, but that would also translate into less downside risk.  They would mainly be trading a regular income stream for the occasional shock.  The main regulatory issue there would be how much leverage put sellers would be allowed to utilize when they sold puts.

Anyway, this is all academic.  But, I like to think about these sorts of things using a different rhetorical framework to try to think more clearly about these issues in a way that separates rhetorical factors from real factors.  Limiting ourselves to the rhetorical frameworks we generally accept seems like it leads to limited solution sets and to solutions that solve rhetorical problems when really, what we need are solutions to real problems.

I hope you haven't found this brief post to be a waste of time.  I welcome comments that point out how ill informed this post is.

Upside-down CAPM, Part 3: Capital Growth

There are problems with the way we talk about capital and leverage.  Frequently, leverage is discussed as if it is a way to multiply the amount of capital we have in some unsustainable way.  During the housing bubble, it is homeowners taking out equity LOCs or investment banks using high levels of leverage in their business models when they were underwriting MBSs and CDOs.  But, leverage doesn't really do that.  Maybe we talk that way because we are thinking in terms of a household taking out consumer debt, or a small business owner getting a loan to make a capital investment, so that for the protagonist in the story, there is some sense of magnifying their economic ownership and risk.  Or, maybe, we are thinking of how banks can make loans, which are re-deposited in the system, seemingly creating capital out of mid-air.

But, none of those things actually increases the real stock of capital.  None of it makes a building appear or stocks a store's shelves.  To do that, capital must bid on the same stock of real inputs that existed before those loans were made.

We might think of the stock of capital something like this:

For this exercise, let's think of public debt simply as deferred taxation.  It might fund some public capital that provides public benefits, but it doesn't have to, and its value is just a claim on future taxes in either case.  So, I am not going to address public debt here.

Private capital might be broadly divided into four categories: Two debt categories that generally have nominally fixed claims and income streams, and two equity categories that generally have nominally flexible claims and income streams based on constantly changing residual income streams to the full basket of income-producing assets.

There is a consumption vs. saving decision that is important on the margin.  But, over time, the growth to the capital base largely comes from growing equity, not new saving.  (I saw a great graph on this recently that I have lost track of.  Please post in the comments if you know what I'm talking about.)  Now, here is where there is a bit of magic.  Let's say Amazon makes some transformative consumer electronics announcement tomorrow, netting $5 billion in new market capitalization.  This means that equity value grew by $5 billion above any investments that Amazon will make in new tangible assets.  I contend that this is an increase in the real capital base, even though it is intangible value.  Amazon might reinvest cash, borrow, or issue stock in order to make that investment, and those activities will affect the stock of capital in the way we normally think about it.  Yet, those are all just reinvestments and shifts in ownership claims.  One could say that the only real increase in the capital stock from that initiative is the new intangible equity value it created.

And that value comes from the real intangible value that Amazon's organizational capital creates.  In the aggregate, this is the primary source of capital growth, and the funding comes from future broad growth in incomes.  Over the long term, the division between capital income and labor income is quite stable.  This means that the added value to business equity that comes from future profits is a reflection of broad-based future economic growth.  In that sort of time-travel hocus pocus that modern capital markets create, the capital base largely grows from its own future intangible value.  The investment Amazon makes has to outbid some other potential use.  It is the intangible increase in value that grows the base of measured capital.

Debt has little to do with this growth.  Changing levels of debt are generally simply changes in the ownership of those future intangibles, between residual owners (equity) and owners with nominal claims and income streams that are fixed in some way (debt).  So, when economic progress happens, some of that accrues to equity.  When equity increases, that actually means that the total capital base increases.  But, when debt increases, that is simply a balance sheet decision by the firm.  The total level of capital remains the same, but the proportions by which it is divided up change.

This is the opposite of how capital seems to be generally understood.

Real estate is no different.  Changing mortgage debt levels are simply a reflection of shifting ownership between equity and debt.  Changing equity levels actually change the total level of capital.  But, the source of value in housing capital is a little tricky.  Business equity value comes from growing future real production.  But, the rent we pay for shelter appears to track pretty closely with about 19% of total personal consumption expenditures, regardless of how much real capital we invest in real estate.  In other words, demand for housing is overwhelmingly mediated by the income effect.  Future income levels are largely a product of investments outside of housing.

If we look at past consumption of housing, there was a great housing boom after World War II, where both real and nominal expenditures on housing grew.  The capital base was growing, part of that was through deferred consumption creating new real housing stock.  When housing expenditures reached about 18% of PCE, that leveled out, and both real and nominal spending on housing remained flat for 20 or 30 years.

By the 1990s, though, we had entered the age of Closed Access, and so, while nominal spending on housing remained level, the real housing stock declined.  This is the period of time where households segregate into metropolitan areas by income.  High income frequently means high rents in a Closed Access city and low income means moving to other cities.  Nominal spending on housing remains level, but Closed Access households are spending a portion of those high incomes on a stagnant housing stock.  Their real housing expenditures (size, commute, amenities) continue to grow at a slower pace than their real incomes.

We can see the shadow of this in the measure of operating surplus to housing.  This is the net income to all homeowners (equity and debt investors, for both owned and rented units) after expenses and depreciation.  Even though nominal spending on housing has been level for 40 years, income to real estate owners has captured an increasing portion of that spending.  That is because Closed Access real estate owners capture income from political exclusion instead of from building new and better units.  Notice that net operating surplus to real estate owners was starting to decline during the big, bad housing bubble.  That's no accident.  The housing bubble was largely the acceleration of the great American housing segregation event, where builders were investing in new real housing stock and households were moving out of the Closed Access cities to other cities where their rent actually paid for shelter instead of transfers to politically protected owners.

During the boom, real estate equity grew substantially - the real stock of capital grew.  But, unlike what happens when business equity grows, this wasn't because future real incomes were growing.  This was a combination of three factors.  First, finally, after decades, new housing stock was being built at a rate that maintained real housing expenditures as a proportion of real incomes.  (That maintained the size of the housing portion of the capital stock.)  This meant that the nation's interior had to build enough homes for its own population and for the Closed Access housing refugees.  Second, low real long term interest rates caused home values to rise.  (I see this mainly as a shift in proportions, similar to the shift we might see if creditors take a larger portion of the balance sheet.  Real estate equity and mortgages grew, but at the expense of business equity, in a complex mix of investment and valuation shifts.)  Third, the capitalization of future rents into Closed Access home prices increased the capital base.  (This did increase the capital base as a portion of domestic income.  But, whereas business equity grows because future incomes will grow, in this case, real estate equity - and debt - grew because they were claiming a larger portion of domestic incomes, which we see in the upward trend in housing operating surplus.)

Because of the way we tend to think about capital, consensus descriptions of the housing bubble get this all wrong.  The conclusion we came to about the bubble was that banks were creating capital by increasing the level of mortgage debt outstanding, and households were using that newly created capital to consume.  This is wrong because lending doesn't create capital, it can only reallocate it between classes of owners.  What was actually happening was that real estate owners were capitalizing their future, bloated rental claims.  The rising levels of housing equity and mortgages outstanding weren't creating capital, and on net they weren't funding unsustainable consumption.  Early in the boom, real estate owners were mostly tapping debt markets to use their capitalized rents to consume.  Non-owners and foreigners provided that capital by shifting it from other capital or by curtailing consumption.  (Foreigners were doing it by maintaining a trade surplus with us.)  But, those netted out.  For every owner shifting consumption to the present, there was another household who was consuming less.  There had to be, in the global sense.  So, real estate owners held politically exclusive assets, this raised future rental income in selected cities, which raised home prices, which raised the value of home equity, and eventually some of that equity was shifted to debt ownership because we don't have a developed system for liquidating home equity to other equity holders.  Partial liquidation of real estate holdings is typically done in debt markets.

The net effect of these shifts was a drag on long term real income expectations, which is why the marginal effect was to keep real long term interest rates low rather than high.

As the boom aged, more owners were tapping those capitalized rents by selling out and moving or renting.  During the later period, there was a transfer of homes from old owners to new owners (either new buyers or investors.)  By then, total value of real estate had peaked, so that the increase of capital in mortgages clearly wasn't increasing the capital base.  There was a large transfer of ownership from housing equity to housing debt.  Much of that transfer was from previous homeowners, tactically reinvesting away from home equity, which had ceased to be considered a safe asset class, and in that search for safety, moving down the array of asset classes, mortgage debt seemed a reasonable resting place, even if that decision was filtered through financial intermediaries rather than being a direct decision of the savers themselves.  For the households taking out that debt, there was nothing stimulative about it.  The debt was simply funding the transfer of their wages to the previous real estate owners.  Those mortgages were a reflection of the reduction in real wages created by Closed Access, manifest through higher rent expenses.

PS. The show Shark Tank is a good example of how this capital creation happens.  Someone with a good idea and little else walks onto the set.  They have very little capital.  They connect with a "Shark" that has the means to capitalize that good idea, and now, suddenly, they have hundreds of thousands of dollars in capital.  If execution of the plan goes well, they will soon have millions of dollars in capital.  That capital appeared as if out of thin air, but it really was created out of the execution of the plan that creates future consumer surplus from their good idea.  That's why it's hard to think about the offers and valuations that are given in a simple mathematical framework, because even if the presenters give up a lot of equity based on their existing business, the payoff really comes from the creation of capital, not from divvying up existing capital.  In that context, one of the "Sharks" may offer a deal that has a debt component, but their shift from an equity stake to a debt stake has little or nothing to do with the capital that will be created from their partnership.  It is just a reallocation between equity or debt forms of ownership.

PPS. These models, along with my narrower viewpoints regarding the housing market and the financial crisis specifically, lend themselves to a coherent and unique asset management process, both strategically and tactically.  I have been gauging interest in that sort of thing among some readers.  If you know of someone or if you have clients that would also be interested in a fund run on these principles, please contact me via the e-mail address in the right margin.

PPPS. So I have this conceptual framework, and I can use to it tell a story about capital.  But, I haven't debunked the other story, have I?  What if everyone else thinks mortgage lending did cause home prices to rise, increase the base of capital, make everyone feel richer, and lead to overconsumption?  Why should you care if I came up with a story?  In the end, this is all rooted in the empirical evidence I have found regarding the financial crisis and the housing bubble.  And, the core empirical evidence that confirms the conceptual model here is the realization that rents explain everything.  The empirical presumptions underlying the other story are wrong.  Not only does my conceptual framework make sense, but it rose out of the array of empirical evidence that I discovered which contradicted the presumptions of the other framework.

If we talked about labor like we talk about capital

We have all seen many articles, such as this one, with the title, "Can't Find Good Workers? Pay Up!"  There is a pervasive notion that morally and practically, wages are always too low and asset prices are always too high.  In the big, bad complicated world, those prices mostly are simply a reflection of fundamental economic reality, so that forcing them in the direction we are predisposed to favoring can create unintended consequences.  Even trying to change those fundamental realities to nudge those prices into a friendly direction might lead to outcomes that are difficult to fully understand.

There are issues where it is the case - that prices are too high and wages are too low - and changing the fundamental economic reality can be beneficial to everyone.  I have gone on and on here about the housing problem, and how allowing new capital into urban housing markets would lower asset prices and increase real wages in a way that would almost certainly be beneficial to everyone (except urban rentiers).  In 2006-2008, we did manage to bring down asset prices, and this was generally cheered or accepted.  But, the fundamental reality we changed in order to do that (credit and monetary deprivation) didn't really have much to do with why asset prices were high to begin with, so we have been drowning in unintended consequences ever since.

But, since this notion that wages are always too low and prices are always too high dominates public thought, in a sort of vulgar way, the Treasury and the Fed have never really been taken to task for the mistakes they made.  Instead, they have been largely criticized for the few things they did right, which were helping to keep asset prices from collapsing for the wrong reasons.

....aaaanyway, when all is said and done, it is a bit disconcerting to me how much of our conception of what has happened is predetermined.  If you get sick, the reaction from someone who believes in evil spirits vs. someone who believes in germ theory will be strikingly different.  It really seems to me that in many cases, our perception hinges on a set of choices that really has that broad of a scale.  This is especially true in complex areas, and that certainly includes finance.  Sometimes books or documentaries regarding the financial crisis even reference demon terminology, as if to make the point.

This caused me to imagine how it would look if we spoke about labor markets the same way we talk about capital markets.........

---------------------------

As the recovery heads toward a decade, it is getting harder and harder for workers to keep counting on the "greater fool" to keep this going.  Employers who are addicted to the gravy train need more workers to feed the beast, but all the good workers are taken.  So, those marginal resumes start looking more and more enticing.  And, wages keep getting pushed up as employers "reach for capacity".

Is there any way these substandard workers will ever pay off for those greedy employers?  Unlikely.  But, "You gotta keep dancing until the music stops." as they say.

As the frenzy builds, the gap between work histories and education on resumes and the actual qualifications of the remaining job seekers widens.  But, who cares?  Those workers get placed through the booming temp sector.  It's not their problem if the worker isn't qualified.  It would be one thing if you were hiring someone to work in your own office, but now we just combine all these substandard workers into one big pool that gets divvied up among employers.  In this frothy market, they naively take those resumes at face value, and the employment agencies pocket their fees.  And the machine just keeps cranking along.

Obviously, we need some regulation to stop this from getting out of hand.  If we had put a stop to the frothy labor markets of the 1990s, maybe we would have had more stable compensation since then instead of the declining labor force participation and stagnant wages that we ended up with.  Federal agencies need to put safeguards in place to prevent labor contracts with inflated wages and to prosecute false applications and resumes.    We all know this stuff is going on, yet have there been any high profile prosecutions?

And, of course, loose money is the grease in the gears that keeps goosing this thing on so that the inevitable collapse will be just that much deeper. (Oh, I guess this part of the rhetoric does stay the same.)

Housing: Part 262 - Self-fulfilling prophecies are highly reliable.

From Calculated Risk:

"Usually near the end of a recession, residential investment picks up as the Fed lowers interest rates. This leads to job creation and also household formation - and that leads to even more demand for housing units - and more jobs, and more households - a virtuous cycle that usually helps the economy recover.

However, following the 2007 recession, with the huge overhang of existing housing units, this key sector didn't participate for a few years."

I'm sure I'm a broken record on this, but it really is amazing how much power our priors have in what seem to us to be empirically derived conclusions.

If the overhang of existing housing units was inevitable, then the protracted recession was inevitable, and there was nothing to be done.  If the overhang of existing homes was a result of our resignation to contraction, and, in fact, our insistence upon it, then the protracted recession was collective self-immolation.

The existence of unsold inventory in 2007 or 2008 tells us nothing about which of those interpretations is correct.

There were millions of willing buyers for that inventory, and those willing buyers ran headlong into a national obsession with preventing them from doing so.  Would allowing that to happen have been a self-fulfilling prophecy, too?  Sure.  The fact that this nation overwhelmingly approves of the self-fulfilling prophecy we chose, even as it bankrupted so many of us, threw workers into unemployment, and destroyed the balance sheets of many young and middle class homeowners tells us just about everything we need to know about the mystery of our ailing economy.

The American populace, paraphrasing "A Few Good Men", barks, "Economic stability?! You can't handle economic stability!"

Sentiment is counter-cyclical. Policy views are pro-cyclical

Quite the chart/poll from today’s @barronsonline pic.twitter.com/gUTLdyfnWu

— NoonSix (@NoonSixCap) October 14, 2017

I thought this was an interesting and telling chart.  And it is a nice piece of evidence against the various macroeconomic theories that are built on the idea that pro-cyclical investor sentiment drives business cycles.

This sure looks like counter-cyclical sentiment to me.

This is related to another great chart that I recently came across.  Sentiment had turned south in the housing market well before 2004.

This counter-cyclical sentiment is, I believe, the reason why we have macroeconomic theories that project a pro-cyclical sentiment.  If sentiment in some group is counter-cyclical, then that group will be convinced that their aggregate sentiment is pro-cyclical.  This is why I am only slightly flippant when I suggest that a reasonable monetary policy rule would be to conduct surveys about what policy shift is most favorable, and then do the opposite.

Think about it.  The reason that it seems like housing markets were out of line in 2005 is because practically everyone knew that prices were too high, yet prices kept rising.  When prices kept rising, lo and behold, there were buyers and sellers who were thumbing their noses at our communal sentiment.  There were even some buyers who were pretty excited about it.

Now, there were certainly some types of buyers and some types of speculators who were more active in the market than usual, at the time.  But, our perception of those buyers is skewed by our counter-cyclical perceptions.  Consider that the housing stock is pretty stable.  We don't suddenly double the number of units in a bull market.  And, think about all the anecdotes from 2005.  Small time speculators who owned a half dozen homes in the sand states.  Janitors in California talked into buying a home with a mortgage that would claim 90% of their take-home pay.  Etc.  Add up all the buyers in your mind.  Think about the fact that for that small time speculator, there had to have been a half dozen former homeowners who sold their homes to the speculator.  There are only so many homes to be owned at any time, with only marginal changes, so those homes had to be bought from someone.

How many articles were in periodicals at the time about all the former homeowners who exited the market?  How many books line the shelves at your local library about how many former homeowners sold out in 2005 or 2006?  For every naïve speculator with a half dozen leveraged homes there must have been several.

Our point of view controls these perceptions as much as facts do, and our point of view is counter-cyclical.  We really notice when market activity betrays our point of view.

We can see this in the stock market in the image above.  As prices rise, sentiment sours.  Yet, the price keeps rising.  How can that be?  It's because price is surprisingly immune to sentiment.  Markets take in a huge amount of primary, secondary, and tertiary investor activity and input.  Market participants may not bid up stock prices because they are in a speculative mood.  Maybe, they bid up prices because prices are cheap, in spite of sentiment, and that fact is manifest in prices, even though our primary market sentiment is weak.

How do we reconcile the chart above with the growing number of anecdotes like this one?

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Uber driver in OC says she and husband were in real estate, lost all in 2008. Only now venturing back into "investment real estate." Hmm.

— Bethany McLean (@bethanymac12) October 14, 2017

---

Do the 4% of potential investors who are feeling bullish and speculative all happen to be Uber drivers and such, or does our counter-cyclical sentiment cause these anecdotes to become more palpable when we are bearish?

We interpret our perceptions as a confirmation of pro-cyclical sentiment.  But, in reality, prices are not particularly sensitive to sentiment.  Intrinsic value of assets is more stable than our sentiment is, but we treat our perception as fixed and we dismiss the efficiency of markets.  So, as our sentiment swings above and below the market, as it generally follows intrinsic value with some small amount of deviation, we come to a conclusion about prices that is the opposite of reality.

And, what is the result?  Where we have the ability and resolve to impose our "theory by attribution error" * on markets, we impose cyclical instability.  When sentiment is bearish, we become convinced that stubbornly bullish sentiment is pushing prices too high, and we demand policies that will dampen economic activity.  When sentiment is bearish, policy becomes bearish, and our sentiments are confirmed.


Update:

Almost 1/4 of those surveyed by E*TRADE expect the market to rise 10% or more during Q4. pic.twitter.com/hduE7Pi3ap

— NoonSix (@NoonSixCap) October 16, 2017

This survey data appears to contradict the data in the above tweet, and suggests that investors expect gains, even though they don't personally think the market is undervalued.  This could be due to speculative fervor, or it could be a realistic expectation of rising real production that causes values to increase along with economic growth.  Even in this survey, the average respondent's expectation is for something just under 5% for the quarter, with a negative skew.  That doesn't seem particularly unreasonable.  But, the negative skew of expectations has definitely declined over the past year.




* "We" base our personal point of view on an assessment of market conditions, the business cycle, and hard earned wisdom.  "Others" are creatures of fear and greed, chasing after every trend.

Housing: Part 257 - Practically everyone predicted a housing bust.

I will chalk this up as one more tidbit of the housing boom and bust that is sort of the opposite of conventional wisdom.

A frequent complaint I hear about the crisis is: How did economists and policymakers miss this?  How did a crisis so severe sneak up on us when the (supposed) excesses of the bubble made it inevitable?

Here is a great graph from Leonard Kiefer of forecasts of housing starts since the late 1990s.

Even as far back as the late 1990s, the median forecast was for declining housing starts.  At that time, housing starts had only just recovered enough from the declines of the early 1990s to get back up to long term averages.  Yet, the consensus was already looking for a downturn.  And, of course, even today, you frequently see people claim that they called the bust as early as 2002 or before.

Calling the bust in 2002 was the consensus!  That's why so many people feel vindicated by the bust.  Most people were calling it, and markets kept defying them.

The problem wasn't that nobody saw a bust coming.  The problem was that there was no need for a bust, but the country had been so bound and determined that surely one was due, that the market's defiance of that expectation in 2004 and 2005 created extreme expectations.  If a bust was due in 2000, imagine how much we needed a bust by 2005!  And, not only had housing starts continued to rise in defiance of expectations, but prices did too.

So, when that terrible collapse started in 2006, the collective reaction was not a demand for stability.  It was a collective demand for letting nature take its course.  Finally, years' worth of expectations were vindicated.  And, the delay it took in coming meant that it might take a mighty correction to unwind the excesses that surely had built up over time.

Even after all that has happened, and after a decade long over-correction, this still appears to be the bias.  I expect that we will see downward expectations again before homebuilding ever reaches a sustainable level again.  We already see reports of overheated markets in the Closed Access cities, where housing starts that can't even accommodate natural levels of population growth look like building booms to locals who have spent a generation or more in deadened cities.  And the high prices caused by the housing shortage only seem to them like further evidence of a mania.

More about leverage and the business cycle

What is the actual evidence for the Austrian business cycle/Minsky idea that businesses are induced to leverage up during expansions, which becomes unsustainable, and eventually must lead to a disciplining contraction?

The evidence seems to me to loudly proclaim the opposite.

Here is a chart of corporate leverage and changing profit margins.

Source

The red line is nonfinancial corporate debt as a proportion of operating profits, net of tax.  The grey line is the YOY percentage change in real operating profits.

It seems clear to me that firms tend to deleverage through expansions.  Where leverage rises, it is generally associated with falling profits that are usually a leading indicator of a coming recession.  The explanation for this seems obvious.  Firms confront negative profit shocks, which cause their balance sheets to shift out of equilibrium.  They cut back on investment in order to try to pull leverage back down to the comfortable level, which over time seems to have moved between about 4x to 6x operating income.  After the contraction, profits rebound, and firms use that expansion to finally allow their leverage to decline.

Here is a graph of these same two series.  Here I have converted the leverage measure so that it also is a measure of the YOY change.  Then, I created a scatterplot of these two series.  Could this be more clear?  Firms clearly deleverage when profits rise.

The change in profit is on the x-axis and the change in leverage is on the y-axis.

Source

Notice where zero is on the x-axis.  There are only a few quarters where leverage as a proportion of operating profit increased moderately during periods of moderate profit growth.  Overwhelmingly, during expansions, firms deleverage.

Housing: Part 252 - The Deceptive Limits of Knowledge

One of the lessons that has really hit home for me in this housing research is how much our assumptions and priors affect our interpretations, and how much our conclusions really are simply a regurgitation of our priors after they have been run through a Rube Goldberg logic machine.  We make so many claims based on a mixture of facts, constructed information that may or may not be accurate, and assumptions that may seem perfectly reasonable but are not.

I can't say that I've applied much of this learning.  I regularly make bold claims based on my own versions of constructed information.  Very early posts I wrote about housing markets contain what I still consider to be clever and well-argued justifications for housing trends, which today I would say generally missed the most important points.  I don't know if anything I wrote was flatly incorrect, but in practice, coming up with the wrong answer to the right question isn't much worse than coming up with the right answer to the wrong question.  Yet, I find it very easy to be confident about my current conclusions, some of which are almost certainly wrong in some way that I will eventually realize.

One example of an assumption that doesn't explain as much as it seems like it should is the idea that cities where people want to live would naturally be much more expensive.  Another is that when mortgages outstanding grow at about the same rate as total real estate values, the growth in mortgages seems like it must have caused the rise in values.  In both of these cases, there really isn't a reason to believe that is the case without corroborating evidence, but it seems so reasonable, that these assumptions can become placeholders in a conclusion that end up doing a lot of the work.  They seem so reasonable, it doesn't seem necessary to vet them.

Yet, in so many cases, just a slight error in how information is constructed can turn our conclusions 180 degrees backwards.

In any case, here is a good example of the problem.  The authors post a chart of high and low tier housing markets, aggregated from 16 major markets.  They note that low tier homes rose higher in the boom years, fell lower in the bust, and now have overtaken high tier homes again.  They tell investors:

If you focus on lower-priced homes, beware that you are investing in a more volatile section of the market from a pricing perspective and beware that lower-priced homes have appreciated the most.

First, there is an assumption problem here.  It just makes sense that lower tier markets are more vulnerable, in the "World to end tomorrow.  Women and children to be hurt the worst." sense.  It makes sense that marginal markets would be most affected by economic contractions.  Defaults would be higher in low tier markets.  So, this conclusion rests easy.  It doesn't seem like it needs to be vetted.

Then, there is a constructed information problem.  Low tier homes were only more volatile than high tier homes during the boom in a handful of markets.  It shows up in their chart, because the 16 markets they aggregate contains all of the cities where that happened.  It didn't happen anywhere outside the 16 markets they reference, and it only happened in about half the markets they do reference.  There is a specific pattern that causes this to happen that is probably mostly tied to maxing out tax benefits on homeownership when homes rise above about $500,000.  Actually, this should provide a little bit of a positive skew to potential gains for investors in low tier homes and a negative skew for investors in high tier homes, because tax subsidies create an asymmetrical set of outcomes for investors that don't claim owner-occupier subsidies.

Source

The first graph here shows YOY high and low tier home prices in LA and Portland going back to 1987.  Notice that there is no systematic excess volatility among low tier homes anywhere until the mid 2000s.  In LA, low tier homes rose higher than high tier homes during the boom, and then dropped farther.  But in Portland there was only a short period, well after the bust had begun, where low tier homes dropped somewhat farther than high tier homes did.

So, there is basically one episode where low tier prices collapsed more than high tier prices, and that happened to coincide with a sharp public policy shift where we essentially made it illegal to make a mortgage to low tier owner-occupiers.  This coincided with a decline in working class homeownership rates in general and a decline of more than 10% in homeownership rates among families that typically used to be first time homebuyers - young families with average or above average incomes.

Recently, it appears that the collapse in homeownership may have finally stopped.  But, this was a one time shock.  You can't collapse a bridge twice.

Source: Zillow Data

So, if we deconstruct their constructed information, we really have two types of cities.  First, we have Closed Access cities, where low tier housing is more volatile than high tier housing, because of these owner-occupier tax issues.  And we have the other 80% of the country, where there never was a difference in volatility, except for that one-time shock.  In a few cities, like Phoenix and Dallas, it appears that population inflows have made up for the lack of low tier demand created by the mortgage shock, and low tier house prices may have recovered back to parity with high tier homes.  But in most cities, from Seattle to Detroit and everywhere in between, there is a very typical pattern.  Prices moved together until the end of 2008, then low tier prices take an extra step down.

(Admittedly, this shows up more clearly in Zillow data.  Low tier markets, in general, seem to have an upward bias and high tier have a downward bias in the Case-Shiller data, compared to Zillow, over time.  This seems to be the case across cities.  Case-Shiller follows individual properties while Zillow takes a market snapshot of all properties at a point in time.  But, I'm not sure how that would create this difference.  So, the volatility is basically the same in Case-Shiller vs. Zillow, but Case-Shiller makes low tier properties look like better long term investments.  The authors use Case-Shiller data, which should make low tier properties look better, but since there has been this z-shaped boom, bust, and recovery, that only makes it look like an unsustainable boom in a volatile market segment.  Another example where a simple difference in a data set of constructed information leads to totally opposite conclusions.)

So, basically the exact same data with a couple of assumptions or facts switched out, and you get two completely different conclusions.  If you account for the mortgage market shock and you use the long term drift in Zillow values, then you're buying up low tier homes in cities across the country with great risk/reward profiles.  If you don't account for the mortgage market shock, you make some reasonable assumptions about market behavior, you aggregate the data among various cities, and you use the long term drift in Case-Shiller values, then you're bracing for a contraction in low tier housing markets that look especially perilous.

These are not massive errors of judgment.  These are tiny little shifts in data with some very reasonable assumptions filling in some harmless looking blanks in the narrative.  And you've got one investor long and the other short - one investor looking at markets always swinging to extreme equilibriums that must correct and another looking at some stable and boring market equilibriums with occasional policy shocks.

More on the "Real Growth" Phillips Curve

I have been trying to build a case for a "real growth" Phillips Curve, where low unemployment leads to rising wages.  Normally, this is associated with rising inflation or with rising labor share of national income.  But I think it mainly equates with higher real growth.  (I think there is a case to be made for labor share of domestic income rising during extended periods of stability.  But, I think this has more to do with capital requiring a lower risk premium than it has to do with things like negotiating power.)

Conor Sen has been noting on Twitter how restaurant margins are getting squeezed by rising labor costs.  It looks like what we have here is a battle between inflationary or labor share versions of the Phillips Curve.  Either restaurants will raise prices and stay in business or they can't raise prices, and their profits will suffer.

But, if we think one more step here, we can see that this is economic growth.  This is sorting.  Wages are rising because workers have better things to do.  In other words, the economy has moved to a new regime where more value can be added somewhere than could be added in the restaurant that used that labor in yesterday's economy.

Sen notes: "We have too many restaurants and a lot are going to close over labor costs and an inability to raise prices."

What will happen, if growth continues, is that the better restaurants will have pricing power, the worst restaurants won't.  Or, more generally, the weaker firms will naturally be the firms that fail.  There will remain a restaurant sector of some size, where wages will be higher and profits will remain at normal sustainable levels.

Interestingly, restaurant employment is growing as a proportion of total employment.  So, this may not even require a contraction in the industry itself.  Weak firms might be forced out by shrinking margins, even as the category remains healthy.

This is creative destruction.  And, we can see quite clearly that this is happening during an expansion.  It is happening because of expansion.  This is the sort of pressure that we need to apply to weak firms in the restaurant industry.

A contraction would also cause weak firms to fail.  But, why would we choose that?

It seems to me that many people see rising wages and they expect that to be inflationary, so they decide that this is unsustainable, and a contraction will pull us back down to earth.  Then, on the other hand, some employers see rising wages and they find their profits being squeezed - in other words, it's not inflationary.  And, they decide that this is unsustainable, and we need a contraction that will pull us back down to earth.

What is really happening is that wages are rising, and this is unsustainable.  We are approaching a better tomorrow.  It is unsustainable in the same way that blacksmithing, film developing, and candlemaking were unsustainable in the past.  Our reaction should be, "This is unsustainable.  Let's keep it up!"

Housing: Part 248 - No, Phoenix didn't build too many homes.

Just a quick post so I can stick this graph here.

The one thing everyone in Phoenix knows is that we built too many homes during the bubble and that is what caused the bust.

Here is an article that claims (HT: John Wake) that, based on stable demand for 35,000 homes per year, Phoenix built 75,000 too many homes, and that was what killed the housing market here.

Here is a graph, from IRS data, of domestic migration into Phoenix, based on the number of households.  There was a massive inflow of new residents fleeing the high priced California cities.  In a normal year, net inflows into Phoenix were about 20,000 - claiming more than half of that stable demand for new housing units.  In 2004 and 2005, that shot up to more than 30,000 per year.  Then, we killed the housing market, and that flow was destroyed.  By 2008, and continuing for years, net inflows have been negligible.  (This graph stops in 2010, but migration into cities like Phoenix has continued to be stifled.)


Source: IRS - number of households filing tax returns

The supposed overbuilding was actually a response to real demand for housing.  And, when that demand collapsed, because migration collapsed, it was a double whammy.  Builders were, of course, building for that high demand.  What were they supposed to do? And, when it suddenly collapsed, it looked like they had built 75,000 too many homes.

The only reason Phoenix had a price bubble is because it couldn't meet this huge boost in demand, so the short term supply inelasticity caused prices to rise.  We can see that in this graph.  By 2005, outmigration was rising in Phoenix, because Phoenix couldn't build enough houses, and so the same migration patterns that were coming out of California started to develop in Phoenix.  People were moving away to escape rising costs.

The frustrating thing is that, during that time, builders were holding lotteries to sell newly permitted newbuilds.  That is insane.  I don't understand how that could have happened.  And, I can't get a straight answer from anybody about why.  When I ask people, they say, "Well, there were all these speculators coming in and buying up houses.  We had to limit new building because they were creating a bubble in supply."  NO!  The bubble was in prices because we were holding lotteries to sell houses.  If you're a speculator, and you see a market where the sellers say, "We are limiting the quantity that we are selling.  If you don't get chosen as a buyer this month, come back next month, where we will release some more limited supply that is guaranteed to sell at a higher price." that is a speculator's dream!  And, when I ask why we were doing that, the response I get is that we didn't want to build a bunch of houses for speculators!

Meanwhile, the migration statistics say that by the end of the bubble, 10,000 extra households were leaving town each year - for want of a house!

Contagion cities like Phoenix have been devastated by the housing bust.  Incomes compared to other cities have collapsed.  We should be outraged.  We should be marching in the streets against tight credit markets.  Instead, the consensus in Phoenix seems to be just as screwed up as it is everywhere else.  Self-flagellation.  Our greed angered the real estate gods, and this is our just due.

The only thing we did wrong was not building enough houses.