Vol. 3, No. 13 — A plague on both your houses
Vol. 3, No. 13 — A plague on both your houses
The housing bubble has burst; Stock prices have risen too high; Using the growth-share matrix and a simple valuation to identify star investments; France faces a debt crisis; Value in hospitals
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In this issue
Quote from Homer J. Simpson
Job board
Cartoon: Titanic rate rises
A plague on both your houses
Cost of capital
A star is born
Global stocktake
Rank and file
Debt cycle monitor
Investment idea
Read time: 30 minutes
Quotation
“This year, I invested in pumpkins. They’ve been going up the whole month of October, and I got a feeling they’re going to peak right around January. And bang! That’s when I’ll cash in.”
— Homer J. Simpson
Job board
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Cartoon: Titanic rate rises
A plague on both your houses
The housing bubble has burst. Those who ignored it and bought on the way up will get burned on the way down.
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Housing is the business cycle. Or so wrote economist Edward Leamer in a 2007 research paper where he argued housing leads the economy. When prices go up, builders build. But the economy sinks when prices drop, and construction activity dries up. That's what happened when the housing bubble burst in 2006. Prices dropped, builders shut up shop, and the economy tanked.
Recently, the housing market has drawn mainstream attention. Prices are down from their peak. Recent homebuyers are nervous. Comparisons to 2008 abound. But are these price drops a minor blip on their way to loftier heights? Or has a bubble burst?
I’ve written 11 articles in this newsletter over the past two years, arguing we're in a global real estate bubble. Common sense tells us prices are ludicrous. The housing market, in particular, is a burning pile of garbage. But vested interests are trying to dress it up as a log fireplace. Rising interest rates have added some fuel to that fire. And, although it's a slow burn, when the smoke clears, we'll see the garbage heap for what it is.
First, houses are still ridiculously expensive—a point I've made before. The gap between the price and intrinsic value of all American housing is vast. Valuing the residential real estate market using a discounted cash flow model suggests it's worth $37trn but costs $53trn. If you bought all the housing in America and leased it out from now until forever, you would have overpaid by 40%. Using the same model on data back to World War II shows the housing market is the most expensive it's been since the '50s. It's even more overvalued than at the peak of the last housing bubble.
Although this model ignores homeownership's intangible benefits, it's a good bubble indicator. The correlation between overvaluation and future returns is strong (-0.5). High prices beget poor returns, while undervaluation leads to stellar ones. Further, this metric isn't biased. The average gap between price and value in those 80 years is zero.
Next, rental yields are too low. The total amount of rent paid in the past year was $2.5trn. This includes owners' equivalent rent, the implied rent homeowners pay themselves. Given the market price of all American residential real estate is $53trn, that suggests a rental yield of 4.8%. As such, if you owned all the residential real estate and had no expenses, you'd make less than 5%. That return is little better than buying risk-free government bonds. But when you take expenses and debt into account, the picture gets worse.
Currently, there is $38trn of equity—the price less the mortgage—in American housing. But after maintenance, taxes, and interest, I estimate landlords only made $343bn of profit in the past year. That's an earnings yield of less than 1%—an abysmal return. Conversely, 30-year Treasury bonds yield 3.9%, more than four times landlords' returns. Of course, rents go up while bond coupons don't. But, even if you assume rents are risk-free, the market price suggests rents will rise at 14% a year for three decades. An absurd proposition. The nation's rent bill has never even grown that much in any period, let alone any individual year. Not even during the '80s.
For current prices to make sense, rents must rise a helluva lot, or the housing market must fall. To return to a 6% earnings yield, the long-term median, rents would have to jump 30%, or prices fall by a quarter. Neither of these will happen on their own. Instead, a combination of the two is likely.
But some pundits maintain it's not a bubble. They say that recent price rises and record equity are proof of that. Although both are true, they are the result of the bubble, not evidence of its absence.
Yes, prices have risen recently. Despite more rate hikes, the Case-Shiller index, a tracker of American house prices, is up 1% so far this year. But rate hikes would never have crashed America's housing market. That's because mortgages there have fixed rates. When rates rise, the cost of an existing mortgage doesn't go up. It only affects those looking to borrow or refinance. As a result, forced sales have not happened and won't in any significant way. But buyers’ purchasing power has dropped.
After a bubble bursts, small periods of price rises are normal. Back in 2006, prices fell from March until August. Then, buyers who thought it was a buying opportunity jumped in. With limited inventory, as owners wanted to wait out the blip, prices rose. They went up until February 2007, when they hit their pre-collapse high. They then fell for the next five years and kicked-off the most significant financial collapse of the modern era.
Yes, homeowners also have record equity. Many housing bulls think prices will only drop if people default or banks force them to sell. Moreover, if they do sell, they have plenty of equity, so it's not a problem. But economists made the same argument in 2006. Back then, homeowners sat on a record amount of equity. Still, that cushion didn't save the market. Landlords thought the slump was temporary and wanted to wait it out. But some buyers, nervous about price drops, also waited. And price drops led to more price drops.
This bubble is different to the last one. Cascading defaults that cause a financial crisis probably won't happen. But fundamentals will win out, and the market will return to where it should be, as it always has.
This time around, the garbage won't burn as hot, but burn it will.
Cost of capital
Finance’s most important yet misunderstood price is capital. Here’s what happened to the cost of money in the past fortnight.
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Stock prices rose last fortnight. The S&P 500, an index of big American companies, climbed 2% to 4,382. The market is 17% higher than a year ago. Stock prices have been resilient in the face of rate hikes.
I value the index at 4,100. That suggests it is slightly overvalued. Excitement over the future of artificial intelligence has buoyed prices for tech companies. But stocks have started to look overvalued.
The companies in the index earned $1,642bn in the past year. They paid out $520bn in dividends, bought back $924bn worth of shares, and issued $69bn of equity.
The forward price-earnings ratio jumped to 18.5. My 12-month forward earnings per share estimate for the index also climbed from $236.20 to $237.40.
Government bond prices rose. The ten-year Treasury yield, which moves the opposite way to prices, fell one basis point (bp) to 3.7%. Investors expect inflation to average 2.2% over the next decade. Their inflation forecast has fallen 30bp in the past year.
The real interest rate, the gap between yields and expected inflation, fell 5bp to 1.5%.
Corporate bond prices also rose. Credit spreads, the extra return creditors demand to lend to a company instead of the government, dropped 7bp to 1.7%. While the cost of debt, the annual return lenders expect when lending to these companies, fell 8bp to 5.4%.
Government bond yields are still the driving force behind changes in the cost of capital.
The equity risk premium (ERP), the extra return investors require to buy stocks instead of bonds, fell 6bp to 4.8%. It’s now 90bp below where it was last year. The cost of equity, the total annual return these investors expect, dropped 7bp to 8.5%. These expected returns are in line with their long-term average and have stabilised.
Equity investors do not see a recession on the horizon.
A star is born
Using the growth-share matrix and a simple valuation to identify star investments.
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