The $20b chart: US real house prices
One of the few investors able to celebrate the bursting of the bubble in US house prices was hedge fund group Paulson & Co. Founder John Paulson personally pocketed $4b. In an article in the Sunday Times on 28th February Paulson and analyst Paulo Pellegrini explained how a single chart of real house prices relative to their historic trend gave then the confidence that a bubble had formed and that they should bet on a crash. It reads as excrutiatingly naive but the funds booked gains of $20b on a leveraged bet of $147m so it was clearly really smart.
I single it out because outsmarting the smarts with simple thinking is very No Monkey Business. In fact, the same data has regularly featured in No Monkey Business posts since 2006 (about a year behind Paulson) as an obvious parallel with the Nationwide deflated index of UK average house prices which I regularly monitored on the No Monkey Business blog from about 2002. Just don’t ask me where my $4b is.
What drew me to the study of the trend and deviations from trend in real house prices was that it was itself a parallel application of an important insight about equity returns: historical time series for ‘real total returns’ (ie cumulative indexed performance with income reinvested, deflated by a consumer price index) contain valuable predictive information for investors, and more so than conventional valuation measures like price/earnings multiples and dividend yields. This was one of the big but simple ideas set out in my book in 2002. Since 1999 it has been the basis of horizon-specific probabilistic return projections in a model we now use to manage Defined Outcome portfolios.
Such an apparently naive solution to a complex problem is deeply offensive to most investment professionals as it implies redundancy for much of their industry. I naturally therefore warmed to the naivete of the Sunday Times account, as typified by this extract.
'Everybody said home prices never had declined on a nationwide basis except during the Great Depression,” Paulson later recalled. He sent Pellegrini scurrying back to his cubicle to determine how overheated the property market was.Tracking interest rates over the decades, Pellegrini concluded that they had little impact on house prices. But as he reviewed academic and government literature and figures, Pellegrini grew frustrated. He couldn’t quantify how excessive housing prices were or show when a bubble might have started. He couldn’t even prove the price surge was distinct from historic moves.Grasping for new ideas, Pellegrini added a “trend line” to the housing data; this illustrated how much prices had surged lately. That’s when Pellegrini took a step back to view things over a longer period, ordering up data on home prices all the way back to 1975. Suddenly, the answer was as plain as the paper in front of him: housing prices had climbed a puny 1.4% annually between 1975 and 2000 after inflation was taken into consideration. But they had soared by more than 7% a year in the following five years, until 2005. The upshot: US home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Pellegrini’s figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop was likely to be brutal. Pellegrini sat upright, staring at his trend line, amazed at how simple and clear it was.The next morning, he raced in to show Paulson. “This is unbelievable,” said Paulson, unable to take his eyes off the chart. “This is our bubble. Now we can prove it.” Pellegrini just grinned, unable to mask his pride.'
The standard source material for real house prices, deflated by general inflation as measured by the CPI, was the S&P Case-Shiller Index. Pellegrini refers to data going back to 1975 but there is in fact earlier data which I came across a little later in the form of index creator Professor Robert Shiller’s submission to a Congressional commitee. In September 2006 I posted an item on the No Monkey Business blog called US house prices: you thought we had a problem which included a chart of over one century of real prices for single-family homes.
It was important that the data be real. Real prices are perhaps better decribed as relative house prices, because they measure prices relative to general price inflation. But even real price series were rarely publicised because of people’s obsession with changes in the price level, treating house price inflation as the key information rather than the level of relative prices itself. This was a widespread problem in the US just as it was in the UK. I still berate newspaper editors for repeating this error.
As I pointed out in my article, fitting a regression trend to the long time series data was not helpful because there were several distinct phases of price behaviour, including just two since the end of WWII, up to and after about 2000: no real growth followed by a growth explosion. In my article, I contrasted the absence of any overall trend in US real house prices prior to 2000 with the trend in post-war real prices in the UK, which has been fairly persistent at about 2% per annum, in line with growth in personal incomes. The 0% trend in the US for some 50 years means that relative to personal incomes US housing had become progressively more affordable. I agreed with Prof Shiller’s interpretation that this was due to easy access to new development land, an endowment we clearly do not enjoy in our planning-constrained small island.
More important, the only plausible explanation for the change in price dynamics after 2000 was the change in credit availability. The fact that people wanted to believe in endless rapid growth, a new twist to the American dream, was a necesssary condition but it also required bankers and mortgage investors to throw caution to the wind or the boom would have simply run out of fuel. And it was the massive stock of derivatives created on the back of securitised mortgages, two symptoms of the credit-induced madness that overtook the housing market, that gave Paulson & Co the instruments, in the form of credit default swaps (insurance contracts that would pay out if the underlying securities fell in price), which had the inherent leverage to turn £147m into $20b. That was convenient but it was also smart and gutsy.