Are Home Prices Low – or Just Right?

Today the Case Shiller index is again released.  Woe is us say the pundits.  But are we again making the mistake of comparing to the wrong base?  Did any of the appreciation of the last 10 years make any sense?  Is there any reasonable expectation that homes will be going back to their values of 2007?

 

Looking at CPI inflation since home prices took off, we see that inflation has averaged about 2.5%.  And with 2.5% inflation in home prices since 2000, the index should be at 135.  Which is just about where it is. 

So maybe home prices are just right now.  Maybe they make sense for the first time in 10 years.  Maybe we just need to recalibrate our expectations. 

The same sort of analysis can be done with equities.  Much press was made off the fact that at some point in the last two years, equity markets stood at the exact same level as 10 years ago, or even slightly lower.  However, ten years earlier, equities were near the peak of the tech stock bubble.  So making any long term conclusions about the viability of equity investing based upon the prices at the top of a bubble is just wrong headed. 

Both houses and stocks are bad buys at the peak of a bubble.  Neither should be expected to beat inflation by 10% per year.   Long term returns should never be based upon bubble peaks but it may be the case that bubble troughs are simply bringing prices back to sensible levels. 

And since this is a blog about risk – it is necessary to point out that expectations for returns that were formed during bubble periods are very risky when the party is over.  

Wrong decisions come from unrealistic expectations.

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Regime Change

If something happens more or less the same way for any extended period of time, the normal reaction of humans is consider that phenomena as constant and to largely filter it out.  We do not then even try to capture new information about changes to that phenomena because our senses tell us that that input is “pure noise” with no signal.  Hence the famous story about boiling frogs.  Which may or may not be actually true about frogs, but it definitely reveals something about the way that humans take in information about the world.

But things can and do actually change.  Even things that are more or less the same for a very long time.

In the book, “This Time It’s Different”, the authors state that

“The median inflation rates before World War I were well below those of the more recent period: 0.5% per annum for 1500 – 1799 and 0.71% for 1800 – 1913, in contrast with 5% for 1914 – 2006.”

Imagine that.  Inflation averaged below 0.75% for about 300 years.  Since there is no history of extended periods of negative inflation, to get an average that low, there must be a very low standard deviation as well.  Inflation at a level of 3 or 4% is probably a one in a million situation.  Or so intelligent financial analysts before WWI must have thought that they could make plans without any concern for inflation.

But in the years following WWI, governments found a new way to default on their debts, especially their internal debts.  Reinhart and Rogoff point out that almost all of the discussion by economists regarding sovereign default is about external debt.  But they show that internal debt is very important to the situations of sovereign defaults.  Countries with high levels of internal debt and low external debt will usually not default, but countries with high levels of both internal and external debt will often default.

So as we contemplate the future of the aging western economies, we need to be careful that we do not exclude the regime changes that could occur.  And which regime changes that we should be concerned about becomes clearer when we look at all of the entitlements to retirees as debt (is there any effective difference between debt and these obligations?).  When we do that we see that there are quite a few western nations with very, very large internal debt.  And many of those countries have indexed much of that debt, taking the inflation option off of the table.

Reinhart and Rogoff also point out the sovereign default is usually not about ability to pay, it is about willingness to make the sacrifices that repayment of debt would entail.

So Risk Managers need to think about possible drastic regime changes, in addition to the seemingly highly unlikely scenario that the future will be more or less like the past.

The Dirty Dozen

Guest Post from David Merkel

The Aleph Blog

I have been thinking about the the forces distorting the global economy.  In the long run, the distortions don’t matter, because economies are bigger than governments, and eventually economies prevail over governments.  Here are my dozen problems in the global economy.

1) China’s mercantilism — loans and currency.  The biggest distortionary force in the world now is China.  They encourage banks to loan to enterprises in order to force growth.  They keep their currency undervalued to favor exports over imports.  What was phrased to me as a grad student in development economics as a good thing is now malevolent.  The only bright side is that when it blows, it might take the Chinese Communist Party with it.

2) US Deficits, European Deficits — In one sense, this reminds me of the era of the Rothschilds; governments relied on borrowing because other methods of taxation raised little.  Well, this era is different.  Taxes are high, but not high enough for governments that are trying to create the unachievable “permanent prosperity.” In the process they substitute public for private leverage, and in the process add to the leverage of their societies as a whole.

3) The Eurozone is a mess — Greece, Portugal, Spain, etc.  I admit that I got it partially wrong, because I have always thought that political union is necessary in order to have a fiat currency.  I expected inflation to be the problem, and the real problem is deflation.  Will there be bailouts?  Will the troubled nations leave?  Will the untroubled nations leave that are the likely targets for bailout money?

4) Many entities that are affiliated with lending in the US Government, e.g., FDIC, GSEs, FHA are broke.  The government just doesn’t say that, because they can still make payments.

5) The US Government feels it has to “do something” — so it creates more lending programs that further socialize lending, leading to more dumb loans.

6) Residential real estate is still in the tank.  Residential delinquencies are at all-time highs.  Strategic default is rising.  The shadow inventory of homes that will come onto the market is large.  I’m not saying that prices will fall for housing; I am saying that it will be tough to get them to rise.

7) Commercial real estate — there is too much debt supporting commercial real estate, and too little equity.  There will be losses here; the only question is how deep the losses will go.

8 ) I have often thought that analyzing the strength of the states is a better measure for US economic strength, than relying on the statistics of the Federal Government.  The state economies are weak at present.  Part of that comes from the general macroeconomy, and part from the need to fund underfunded benefit plans.  Life is tough when you can’t print your own money.

9) The US, UK, and Japan are force feeding liquidity into their economies.  Thus the low short-term interest rates.  Also note the Federal Reserve owning MBS in bulk, bloating their balance sheet.

10) Yield greed.  The low short term interest rates touched off a competition to bid for risky debt.  The only question is when it will reverse.  Current yield levels do not fairly price likely default losses.

11) Most Western democracies are going into extreme deficits, because they can’t choose between economic stimulus and deficit reduction.  Political deadlock is common, because no one is willing to deliver any real pain to the populace, lest they not be re-elected.

12) Demographics is one of the biggest  pressures, but it is hidden.  Many of the European nations and Japan face shrinking populations.  China will be there also, in a decade.  Nations that shrink are less capable of carrying their debt loads.  In that sense, the US is in good shape, because we don’t discourage immigration.

From David Merkel

The Aleph Blog

This post is produced by David Merkel CFA, a registered representative of Finacorp Securities as an outside business activity. As such, Finacorp Securities does not review or approve materials presented herein. By viewing or participating in discussion on this blog, you understand that the opinions expressed within do not reflect the opinions or recommendations of Finacorp Securities, but are the opinions of the author and individual participants. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security or other instrument. Before investing, consider your investment objectives, risks, charges and expenses. Any purchase or sale activity in any securities instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Finacorp Securities is a member FINRA and SIPC.

Protected by the Crowd

A major question for risk managers to ponder is whether it is sufficient to be protected by the crowd.

What I mean is whether they can feel that they are doing their job when they are ignoring the same risks that every one else is ignoring.

An example of that is inflation risk.  Inflation risk does not appear on most firms list of major risks.  But if there is inflation, their expenses will rise, their cost of borrowing will rise, the values of their stock and bond portfolios will fall, their claims costs will rise – all for certain and possibly, just possibly, their prices and their earnings on investments will rise enough to compensate for all of that.

But most firms take the approach that if they do not put inflation on their list of risks, then they do not have to deal with it.

Inflation can be like the rising tide eating away at the child’s sandcastle on the beach.  It does not appear anywhere near as inevitable as it is.  During the low tide, the sand castle appears more than strong enough and plenty far away from the water.  But slowly, slowly the tide works its way up the beach until eventually the castle is completely swept away.

And if everyone does not prepare for inflation, then the price increases that everyone will be able to get will most likely be enough to survive.  Because everyone in the market will need the price increases to survive themselves.

So all it takes to ruin that situation is for one significant competitor to screw it all up and to prepare for the risk of inflation.  Like the one airline that hedged their fuel costs.  They did not need to raise prices when oil prices spiked, so therefore, everyone that competed on routes with them had to eat the cost of their lack of risk management.

The same will be true with inflation.  Some firms will prepare for inflation.  They will not depend on being protected by the crowd.  And they will spoil it by refusing to raise prices as much as the firms that were not prepared need.  The unprepared firms will be stuck with several bad choices – losing business,  doing business at an unsupportable price or cutting costs that may not have any fat in them already.

The U.S. government on Wednesday said it will expand sales of Treasury securities that help investors hedge against inflation risks, a move aimed at improving management of its ballooning debt sales while boosting buying interest at home and abroad. (WSJ)

There has been an excuse, however.  Inflation has been difficult to hedge.  But with the above program of expanding the offerings of TIPS, the cost of hedging inflation may be reduced to something more similar to the hedge costs for other risks (I mean the transaction cost part of the cost of hedging).

The interesting thing about the story behind the TIPS change is that TIPS cannot be said to be a very successful program to date – largely because of the fact that most people and most firms choose to hide in the crowd for this risk.  The TIPS market has been just too thinly traded.  However, the WSJ article says that the TIPS are now seen to be a way to protect foreign investors against rampant dollar inflation.  If the US government must make inflation adjusted payments for a significant fraction of the debt, the WSJ article thought that might be a disincentive to the government excesses that drive inflation.

I wonder if the people who wrote that have heard of the inflation plagued countries where everything is indexed to inflation.  It makes inflation into a more bearable fact of life.  That seems to be a dangerous path to start down.

All Things Being Equal

is a phrase that is left out more often than left in when it is actually a key and seldom true assumption behind an argument.

If you are talking about risk and risk models, that phrase should be a red flag.  If the phrase is actually stated, the risk manager should immediately challenge it.  Because when a major risk becomes a loss or threatens to become a loss, very rarely are all things equal.

Most, and possibly all, major loss situations have ripple effects.  These ripple effects may be direct or they may be because they affect people who then in turn take actions that cause other unusual things to happen.

Here is a map of how the World Economic Forum thinks that the major risks of the world are interconnected:

Another example of a problem with the “All things Being Equal” assumption is the discussion of inflation.  Few people remember to say it but when they worry that addional money in the system due to direct Fed actions or Stimulus spending will cause inflation – that would be true – ALL THINGS BEING EQUAL.  But in fact, they are not equal, or even close to equal.

What is different is the amount of money that was in the system prior to the crisis other than the money from the Fed and the Stimulus.  The losses suffered by the banks and the shrinkage of loans and the inability of consumers and businesses to get loans – each of those things REDUCES the amount of money in the economy.  So in no stretch of the imagination are all things equal.

So the old rule about government spending being inflationary is only true ALL THINGS BEING EQUAL.

That does not, however, mean that there is not a difficult task ahead for the Fed to try to discern how fast the total money supply catches up with the economy so that they can reel back the money that they have put in.  But the problem with that idea is that because of the amount of economic activity that has been totally privatized, the Fed does not necessarily have the information to do that directly.

So ALL THINGS BEING EQUAL, they will have to try anyway by looking at the pick up in activity from the parts of the economy that they do have information about.

Meanwhile, folks like the NIF are looking to help to improve the information flow so that proper management of the money supply is possible from direct information.

Inflationary Expectations

Guest Post from Max Rudolph

Financial expectations have a way of holding up mean reverting processes, making them sticky. Inflation expectations are famous for this, with workers anticipating future levels of price increases and demanding higher pay to compensate. When rates stay abnormally high or low for long periods, especially when it is artificially induced, the changes to catch up are especially large and swift. That is the position we are in today. Short term rates are being kept low through Federal Reserve policies. This is the same policy over the past decade that produced several asset class bubbles and increased systemic risk until it nearly took down the financial markets in late 2008. Now a combination of factors are building that will lead to high rates. There are a number of reasons for this, some new and some old.

Building Pressures

Many of the unfunded accruals have been documented elsewhere, but it recently became obvious to me that there are now so many that our path is predestined. It’s not obvious how to avoid these issues through an investment strategy today, but a stress scenario that considers long-term Treasury rates of 10% or higher should be included in any strategic planning exercise. Here are some reasons why.

• Federal deficit – you can’t print this many dollars without increasing inflationary pressure

• Trade deficit – we need dollars to buy oil and other imported goods. We don’t export a comparable amount, so the dollar’s inevitable trend is down. This is inflationary.

• Unfunded mandates

o Social Security (annuity benefits) has a trust fund backed by promises of future taxpayers to pay retirees but little more than that.

o Social Security (health benefits) has little in the trust fund today. It will get much, much, worse over the next 30 years.

• Willingness to bail out anyone and everyone – it is hard to argue that everyone who received federal bailouts so far were systemic risks by providing these funds, implied promises were made that others would be helped too. This incents more risk in the system. Besides the union vote it is hard to argue that GM is now a systemic risk, yet lots of my money is being passed through to them and others who lacked understanding of risks and lived by the lobbyist. An academic should do a correlation study between lobbying expenses and bailout money. I think we would find that the first department to go after a bailout should be lobbying to push out the private sector by buying troubled assets. More market feedback is needed.

• Giveaways have no plan to slow down – several stimulus plan programs continue to push out the private sector by buying troubled assets. More market feedback is needed.

• Waiting in the wings – others are waiting to be bailed out, including states, municipalities and municipal insurers.

It occurs to me that a politician’s legacy can change long after he/she is out of office. I wonder if Franklin Roosevelt, champion of the retirement safety net, has yet to meet his fate. If the United States government is bankrupted at some point due to generous benefits to seniors and federal deficits under a Keynesian mantle, it will put a new perspective to his ideas.

Waiting in the wings – others are waiting to be bailed out, including states,

Warning: The information provided in this post is the opinion of Max Rudolph and is provided for general information only. It should not be considered investment advice. Information from a variety of sources should be reviewed and considered before decisions are made by the individual investor. My opinions may have already changed, so you don’t want to rely on them. Good luck!