Picking stocks and housing bubbles

Robert J Shiller

Professor Robert J Shiller won the Nobel prize this year (with Eugene Fama and Lars Peter Hansen) for his work on the analysis of prices of various assets.

He repeated his Nobel lecture at the Yale School of Management yesterday, and I grabbed a couple of screenshots from the livecast.

His early work tested whether the value of shares is equal to their future dividend streams, and it did. Later he observed that the volatility of share prices (against his model) was mainly due to “innovation” from the companies and the market.

Picking stocks
For me this means investors should hold stocks in companies which have secure dividend streams for regular portfolio growth (e.g. Meridian), pick stocks in companies that will deliver disruptive innovation to get outsize returns (e.g. Xero), and avoid stocks where the companies are subject to being disrupted by innovators and are unable to respond (e.g. Yellow).

Later in his career Shiller came up with the definitive house price index for the USA, which tracks prices for repeat sales:

I raise this because he then put up a slide of Los Angeles house prices versus personal income, relating a story about how extreme ratios a few years ago made it hard for people to choose move there.

 

So how are we doing in New Zealand?

Even I, a housing price cynic, was shocked by the result when I crudely replicated the analysis.

Our latest median (as opposed to average) house price, according to REINZ, was $425,000 in November last year.

The latest statistic for median income in New Zealand from NZ Statistics is $29,900, from the June Quarter last year. That gives a ratio of $425,000/ $29,900 = 14.21.

That wouldn’t even fit on the chart above, so here’s how it would need to be amended to show New Zealand.

A bit more searching and I found the 2004 paper where Case and Shiller asked “Is there are bubble in the housing market?“, and showed that while for most US States the housing prices were directly related to income, but a few (about eight) states were well out of whack, showing more volatility along with higher average ratios.

Click to zoom.

Picking Bubbles
The chart that Shiller showed above shows that the LA prices dropped by over 50% versus income from 2006 until now. My own take is that there is clearly also room in New Zealand for a very very steep plunge in house prices. It would need a catalyst, but let’s remember to not blame whatever that catalyst is, but the system of incentives that has delivered us this ridiculous and very dangerous situation.

And remember – if you are selling your house, then its smart to do so using the latest tools, real estate agent experience and low commissions at 200Square.


UPDATE: This is the housing index that Shiller put together. How I would love to invest (short) on this for NZ.

Click to zoom

Lance Wiggs is an independent consultant providing management, strategy, growth and valuation consulting to industrial, media and internet based businesses. He blogs at Lancewiggs.com

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25 Comments & Questions

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A good and insightful piece of analysis Lance.

However one important thing to understand is the impact of leverage which is freely available for houses and limited for shares. Xero shares, as an example, could only be used by the likes of Leveraged equities and others for the last short while meaning investors missed out on the first five years of spectacular returns. Until banks lend on shares (and bank managers appreciate and understand shares) there will continue to be housing bubbles in NZ.

When the housing bubble finally bursts (which will happen - it is only a matter of when, not if) then the share market crash of 87 will look like a walk in the park and a number of NZ banks will fail or need parent company support from their Australian masters. At that stage Mums and Dads will really get burnt !

If I were a betting man that time is late 2014 with the catalyst being the election or threat of a change and the impact a falling currency will have on foreign owned banks and offshore funding that the banks rely upon.

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What if instead of the bubble bursting house prices stagnate for a decade and inflation eats away at the high prices? Not quite as dramatic but equally likely.

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More than equally likely. A dead certainty I'd say.

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You can't look at income alone but rather disposable income. In New Zealand we have free healthcare and schooling while in the USA approximately 25-30% of disposable income is spent on healthcare and schooling leaving little for financing housing. Of course there are some benefits in the US such as deductibility of interest that offset these differences. In addition US housing finance can be non recourse which creates significant volatility as rather than hold an asset when it is under watt the great Americans just use jingle mail and send their house back to the bank. NZ finance is not so lenient so people would rather stop shopping than not pay the mortgage and be in debt without the house. All subtle differences but like mr Schiller says an asset that has no alternative is more valuable. This is the case in NZ but not do clear in the USA.

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NZ household debt (vast majority mortgage) is around 150% of disposable income, one of the highest in the world and far higher than the US.
And in the US you get 20 year fixed mortgages and mortgage interest deductibility. The whole "non recourse" argument is also spurious as it's not that easy to walk away from a house in the US.
Here its all floating or very short term fixed (max 5 years) mortgages with steep rate rises already being priced in. 2014 will be the last gasp of an already stuttering house market. High Chinese interest rates, weak pound and aussie vs kiwi will dry up offshore buyers and rising interest rates here will cripple local buyers.
We're in for flat pricing in good Ak school zones and declines everywhere else over the next 2-5 years. Prices have already come off since the frenzy in spring last year, just ask any real estate agent. That's why 90% of houses in Ak are now "for negotiation" now whereas they were all for auction 6 months ago. The buyers have dried up...

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Oh Lance...

Whilst I like Schiller, Gene Fama shared that Nobel and he would point out that the market has taken all of the available data, including Auckland's rising population and restrictive housing consent process, and worked out that unless either income collapses or construction rises, their will be a housing shortage.

You can short the Auckland housing market; sell your house. Hickey did.

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Already done that - I don't own a house - I rent and have invested fully in early stage companies.

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The housing bust in the US was caused by many factors including easy credit and massive speculative building by developers and housing companies. When the crash occurred there were vast completed but unsold housing estates all over the US. This over supply created further impetus to the crash ie more sellers than buyers.

In NZ it is very hard for house builders/developers to "speculate" on the market like they were able to in the US. The banks have always required very high pre sales before they will fund a project.This is perhaps the most important regulator of supply of new housing stock into the market. There is no sign the banks are going to change this core credit philosophy albeit they may free up criteria around the edges.

Another key feature which regulates supply ( particularly in Auckland) is the geography of our country. Unlike many urban areas in the US which are built around vast flat easy to develop landscapes NZ is generally mixed steep topography and in Aucklands case a very narrow isthmus which significantly restricts easy large residential development. These features restrict supply and mean our market very rarely gets massively over supplied - and when it does it only impacts the market for a few years and prices fall marginally ( 10% - 20%).

I realize Case Shiller have rightly received a Nobel prize for their insightful work on the US market. But simply applying their logic to NZ and then coming to a conclusion that our market is a big short seems too simplistic to me ( with respect Mr Wiggs).

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It's these sort of silly, false anecdotes that frustrate me and most rational property commentators. Developers speculate in Auckland all the time. This is why a bunch went bust just after the financial crisis here. And who knows how well Hobsonville Point etc will go in sales.
Go look at the data. Medium term returns for property in Auckland is in the 5-6% nominal range per year on average. This is around 3-4% after inflation. But the market is highly prone to booms and busts-yes, the Ak market has fallen by c8-10% at least twice in the past 10 years, and just after upward spikes. The same is true of Sydney. And it fits perfectly the Shiller argument of high priced markets being more volatile.
If you doubt me, then go and research it, the REINZ and Barfoot both regularly state price movements over time which prove my point about mediocre 10 year returns.
Those buying houses today are in for a world of hurt as interest rates rise and prices correct, as they always do.

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Waney wakey thanks for your comments. But the fact you raise Hobsonville merely shows me you don't have all the facts. Hobsonville is owned by a government owned entity Hobsonville land company limited because of this it is well capitalised and conservative. It is only realeasing land to meet demand. The builders operating there are restricted and controlled in their activities. There will be no over supply there and prices will remain within a range otherwise Hobsonville land company will simply restrict supply, I know you want to hear that the market will explode and people buying now will lose their shirts - however it's not as simple as that.

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You stated you used the median average rather than the mean average. Was Schiller using the mean or the median? And would not the mode be the most applicable?

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Average is the sum of all the numbers divided by the number. It is also called the arithmetic mean.
Mode is the most common number.
Median is the middle number when all the numbers are ranked

Average, for datasets like these, gets skewed by ultra-expensive houses, which may or may not sell in a particular month in a particular area. As we are trying to check affordability for us all rather than a few, it's not that useful.

Mode, while interesting, is a bit of a chance statistic.

Median, the middle number, is the best way to represent the data. It's not perfect of course, and I'd love it if we would look at the 90th and 10th percentiles and so on each time, but then we would not have one single number.

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Lance - did you take the NZ median "individual" income or the NZ median "household" income? It's unclear if your back of the envelope calculations are comparing apples with apples - surely it is household incomes which are more relevant for measuring household indebtedness.

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I've noticed that there are always doomsdayers in the middle of the "latest" boom predicting the next downturn and garnishing it with predictions of cataclysmic consequences. And of course they are always right, it's just the timing they get wrong.

In my opinion 2014 is going to be huge for New Zealand in most aspects of the economy. While Auckland property has really boomed and Christchurch (for obviously different reasons) , the rest of the country is in different stages of growth and catching up.

Many parts of NZ property markets are still flat and significantly devalued relative to their former 2007 peak. Income disparity between regions is huge, meaning rents achieved in main centres will never be achieved in small towns. I think it's to simplistic to analyse all markets in one and lump them together. Like every country, there are regional differences to cycles. You can't just lump it all together and look at the mean result. You can't compare the fundamentals of Auckland incomes and it's land scarcity to say, Napier with its looser land supply and lower incomes. You can't say just because one market has peaked, others will or won't catch up. You need to look at the individual market fundamentals. Tight V loose land supply, population growth, income levels, rental yields, etc.

To compare NZ to America is not a good comparison either. We have much higher costs of construction and much much tighter land supply in the key driver markets.

I have investments in the USA. The USA property markets are completely different animals state by state. You effectively have 52 different countries in America when it comes to property, each one with different drivers and cycles, different tax systems by state. Means of the gross statistics for the USA are almost meaningless.

In summary of course there will be a downturn, of course we are in a bubble, and as long as there is loose credit and inflation, this cycle will continue over the long term. 2014 will be awesome for business and property in NZ in my view. They are even talking about it on CNBC. I wouldn't be surprised if it carries over into late 2015. I work in property circles, and my clients are all very very positive. Shades of 2006 enthusiasm and speculative intention everywhere. It will blow up and come crashing down, but no time soon unless there is a shock event like withdrawal of cheap credit.

Oh one more thing , you can't beat Auckland's scarcity story in NZ in the next decade. The Auckland strategic plan for high density guarantees tight supply of land. It will be years before the unitary plan rules are clear and infrastructure to support catches up. Immigrants and regions flock to Auckland locking in demand for housing. Coupled with poor performance in council consent processes and their anti-developer attitude, you have a cocktail perfect for sustained growth for at least 10 years.

I'm typing this on a phone so apologies for any typo's.

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All valid points and i also have property investments in the US and Europe and work in property investment.
What everyone misses with NZ, and what all these anecdotal opinions ignore, is that there are no real fundamentals driving the Ak market in recent years, just cheap credit. The recent census data dispelled the myth of population growth outstripping building-they have perfectly matched and population growth has been very low in reality, around 1.5% per annum in Ak. Go to the statistics Dept website to read the facts.
Couple this with low wage growth of c2-3% and this justifies the c5% average price growth in housing. Deviations from this average growth are fuelled (up and down) by household ability to service debt.
In periods of low interest rates, people borrow more, provided they have job security, and this fuels price bubbles. This is precisely what we have had in the past year in particular in Ak. A bit better feeling of job security given the economy is better, and once in a lifetime low interest rates. But this is ending. Growing economies generate inflation and central banks hike interest rates in response-exactly as is happening in NZ right now. The higher interest rates mean buyers can borrow less and hence asset prices stop rising and generally fall. Its a universal law.
I challenge anyone who disagrees to tell me where people get the money to service a bigger mortgage if their interest rates just increased by 30%! (Ie from 5% to 6.5% or 7%). You cant "hype up" more income. You can only borrow less. And if you have a fixed amount of savings for a deposit and less debt available, how do you pay more for a house? It's pretty simple maths-you dont, you offer less. And if everyone is in the same boat, then everyone offers less. And if vendors want a sale, then they have to accept less. Demand and supply at work to find a clearing price.
All property investors known that property moves in cycles and the biggest drivers are interest rates and economic growth (the direct proxy for housing being unemployment rate). We are entering the stage of the cycle where credit tightens noticeably as interest rates rise. This is never good for property prices, particularly when incomes in NZ are not rising quickly and population is not growing very fast either.

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And not all supply/demand trends stay the same either.

For example, more baby boomers and Gen Xers have opted to live alone than in previous generations, and with average occupancy rates being lower, more dwellings have been needed. I

'm no expert, but the next generation doesn't seem as keen to follow this trend. I wouldn't be surprised if groups of friends decide to buy property together. Also, as interest rates rise, more home owners may start renting out the spare room. Changing trends like these could lead to a significant reduction in the number of actual dwellings needed.

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All these people who can pick the market top, why they must be the richest people in the world!

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Wonder if they got the guts to risk their own monies.....?

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As I said - we have no way to short the market (and even if so - I'm fully invested).

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Is this a news article or an advertorial NBR? If writers are going to link to a company they are involved in could you please use a disclosure statement? Journalism 101 anyone?

Defining bubbles is only easy with hindsight. We also need to think about why prices are increasing and in the case of Auckland I suspect it is more about supply shortage rather than bubbly speculation. If we are in a bubble - bubbles have a way of persisting way way longer than seems rational. Shorting a bubble without deep pockets is very very tough. It is really easy to make a bearish call and be wrong for years, then when thee fall actually happens to feel vindicated. Even Shiller (who I respect immensely) recognises that you can eventually be right but in the long run be worse off because you have been out of the market for so long. As an example in US equities there are notable commentators who have been calling for a 20% correction since early 2013 (and earlier). One year return is 26% so even if they are right they are not even at break even.

Even the Case Shiller index bears this out. If you take 30/9/2002 as the time to short the market as per Shillers call, the index was at 131.53

The index peaked at 30/42006 at 206.62 - thats close to a 60% loss of capital from call to peak. Then from 31/3/07 we see a rapid decline to 31/05/2009 at 140.83 and a few years of meandering to a low of 137.04 at 29/02/2009. Now we are back at 164.08 at 31/10/2013.

So yes Shiller was "right" but from the time he made his call in 2002 the 20 city index never got back to his "short the market level."

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On my blog it's obvious that I'm affiliated with 200Sq - but you are correct that it's not here. For the record I am a shareholder and a director.

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Lance, I think you should have used averages rather than means, and plotted several years, just to see what the pattern is for NZ. But thanks for drawing our attention to it.

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Don't use averages of income and house prices - really needs to be by region? Still interesting....

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All impeccably-earnest stuff but people have been predicting a crash in the housing market for much of the past 20 years ("prices to fall 30%" etc etc") and it still hasn't happened.

From the tone of many of these comments it seems like plenty of people really want it to happen. Maybe the Cassandras would happily see the economy destroyed to be proven right.

Nobody can forecast the future but with the economy growing and very high levels of interest from overseas buyers it seems unlikely.

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".......and it still hasn't happened". Wait to see if we have a Labour/Green government before you speak.

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