“A bubble is a bull market in which you don’t have a position.” – Eddy Elfenbein, Founder of CrossingWallStreet.com
Home prices on a national basis have been on the rise for over four years now. This past June marked the 50th consecutive month of year-over-year national home price appreciation according to a new report put out by Black Knight Financial Services. Looking at the Case-Schiller U.S. National Home Price Index, home prices are now within 2% of surpassing the all-time highs set back in July of 2006. In some markets, housing prices have appreciated well beyond their 2006 highs and continue to move upward. With all of this positive momentum and the memory of the last housing crisis still fresh in everyone’s minds, many are wondering whether we are in yet another housing bubble.
Before we try to answer the question of whether the US housing market is in a bubble or not, let’s first talk about bubbles. The term bubble was not a common part of the economic vernacular even 20 years ago. Since that time we have gone through two major stock market sell-offs of greater than 40%, oil prices dropping from over $100 a barrel to less than $30 a barrel twice, and a six-year nationwide bear market in housing prices, which was previously thought to be impossible. With all of that in the recent past, it is no wonder that everyone is on bubble watch. But the problem with bubbles is that they are very hard to predict, impossible to perfectly time, and can really only be identified in hindsight. Too often people like to talk about bubbles simply because the price of a good that they don’t own is going up in value as the opening quote aptly stated. So with all that in mind, we will try to answer the question of whether or not the U.S. housing market is in another bubble, but understand that we do this with a great deal of humility and recognition that we could be 100% wrong!
Our short answer to the above question is that we are not in another housing bubble. We came to this conclusion by looking at a number of different factors in addition to simply measuring the change in prices. One study conducted by Realtor.com looked at six different factors they considered crucial to the inflation and subsequent burst of the previous housing bubble, including: price change, prevalence of house flipping, ratio of cash buyers to mortgage financed buyers, home price to personal income ratio, housing cost to rent ratio, and housing starts to household formation ratio. The weights assigned to each factor were not disclosed, but the chart below shows the top 10 bubbliest markets in the U.S. today and compares their score to where they were in 2005 near the peak of the previous bubble.
Understanding that Realtor.com has an obvious agenda of talking up home prices and that data can be manipulated when it comes to an arbitrary index, the takeaway is still interesting in that even the hottest markets in the US still have yet to reach maximum froth versus the previous go round when you look at factors beyond just simple price appreciation. Along these lines, here are the top reasons why we feel the current housing market is on much better footing than the housing bubble.
Tighter Lending Standards
Agree with the move or not, the Federal Reserve and the U.S. Tax Payer basically saved the banking system from the brink of collapse during the Financial Crisis. Many banks are still licking their wounds from this experience in addition to dealing with a host of new regulation (Dodd-Frank in particular) which came out of the crisis. As such, lending standards are much tighter today. Mortgage credit scores are 30 – 50 points higher today than they were during the bubble peak. In order to qualify for a Fannie Mae backed mortgage, you need a FICO score in the 740-750 range versus 710-720 in the bubble years. Even FHA mortgages are demanding higher credit in the range of 690 – 710 versus 650-660 in the past. Lastly, and most importantly, the exotic loans (e.g. no down payment, no income verification, interest only, negative amortization, etc.) which fueled the final leg of the housing bubble are all but extinct today.
Tighter lending standards have also led to homeowners having more skin in the game. According to the same report by Black Knight referenced earlier, homeowners today are currently sitting on 44% aggregate equity versus 25% during the peak of the bubble. Although aggregate equity is not in and of itself an indication of whether a market is bubbly or not (by definition equity should increasing as bubbles inflate), it does show that speculation isn’t running as rampant as it was a decade ago.
Supply vs. Demand
One common metric in real estate is to look at months of supply, which measures how many months it would take to sell through all the available inventory at the current sales volume. In other words it is available housing stock divided by monthly sales volume. Currently this value stands at around 4-5 months which is right in line with where it peaked during the housing bubble. On the surface, it may appear that this is actually a case "for" rather than "against" being in another housing bubble, but we need to unpack this metric a bit further.
During the housing bubble, months of supply was low because sales volume (denominator) was running at a frenzied pace fueled by extremely careless lenders, so sales volumes were running at around 8.4 million. Today that volume sits at around 5.8 million or roughly two-thirds of the peak volume from 10 years ago. The reason months of supply is so low today is more due to low supply (numerator) than rampant demand. For the four years leading up to the bubble bursting, home builders were constructing around 1.9 million homes per year. Over the past four years, this numbers has hovered at just under 1 million or roughly half the pace of the bubble years. Once bitten, twice shy.
Although housing prices have been on the rise for the past four years, housing affordability has remained relatively strong due to the continual downward move in interest rates. According to one article we read, a home owner who makes an average salary and puts in a 20% down payment will have a mortgage burden of only around 15% of his/her gross income. This ratio got as high as 25% during the bubble years and has longer-term historical averaged of around 20%. What this tells us is that all else equal (e.g. interest rates remain low), housing prices have more room to run from an affordability standpoint.
In summary, the pulse of the national housing market today feels a lot different than it did during the last housing bubble. Speculation has remained somewhat in check due to tighter lending standards and the recent memory of the past cycle, while affordability is still strong due to record low interest rates. The chief economist at Realtor.com went on record to state that the circumstances of today’s market are in stark contrast to what we had a decade ago.
The havoc during the last cycle was the result of building too many homes and of speculation fueled by loose credit. That’s the exact opposite of what we have today. - Jonathan Smoke
It remains to be seen if we really are in the early, late, or any stage of another housing bubble but it is safe to say that if we are, this go round doesn’t look a whole lot like the last. Also, it is important to remember that all of the data points we have looked at have been based on averages for the entire country. Any given sub-market can look a lot different than the national averages. A final point we would like to make is that the logical outcome from uber-Keynesian central bank policy which attempts to steer markets through top-down intervention is dislocations in free market pricing…also known as bubbles. So even though we don’t believe the aggregate US housing market is currently in a bubble, we are fully aware that bubbles are much more commonplace today than they have been in the past.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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