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The linear trend line does not support this theory but let's give it a try anyway. Let's use the average value of the ratio in the chart above to generate a new trend line in the following chart below.
The trend line is simply the replacement-cost value of structures times a fixed average ratio of 1.45.
That is one interesting chart to me. I'm liking this theory.
Let's come up with a new theory that expands on this theory. What if there is a constant ratio between the replacement-cost value of structures to the replacement-cost value of durable goods?
Once again, the linear trend line does not exactly support this theory but let's give it a try anyway. I am once again using the average ratio to generate the trend line in the following chart.
The trend line in the chart is the replacement-cost value of durable goods times a fixed ratio of 2.41.
I know what you must be thinking. Mark, you are an idiot. We are being swamped with cheap overseas goods. How could this ratio be a constant? I would counter with this. Where are our durable goods jobs going? Without jobs, how can we afford high priced real estate?
Okay, now let's come up with a grand unifying theory of real estate malinvestment. First we assumed that there was a constant ratio between real estate market prices and the replacement-cost of structures. We next assumed that there was a constant ratio between the replacement-cost value of structures and the replacement-cost value of durable goods. It doesn't take a great leap of logic to therefore assume there must be a fixed ratio between real estate market prices and the replacement-cost value of durable goods.
It's sort of my way of saying that the value of the car you park in front of your house is in some way related to the actual price you should be paying for the house. I know. This sounds like heresy, but let's try anyway.
Once again, the linear trend line does not support this theory. Something truly amazing is about to happen though. We're going to plug that 3.53 average ratio into the following chart.
The trend line is simply the replacement-cost value of durable goods times a fixed 3.53.
Wow. Can anyone say reversion to the mean? If this theory is true, then our economy has been an illusion of prosperity since 1997, because that is the year we first started deviating from the trend line.
You will note that I didn't once have to mention credit, the apparent "lifeblood" of our economy. Debt is the main event of our economic freak circus. This was simply a side show. Next up, a few words from the bearded lady.
October 27, 2005
Bernanke: There's No Housing Bubble to Go Bust
U.S. house prices have risen by nearly 25 percent over the past two years, noted Bernanke, currently chairman of the president's Council of Economic Advisers, in testimony to Congress's Joint Economic Committee. But these increases, he said, "largely reflect strong economic fundamentals," such as strong growth in jobs, incomes and the number of new households.
I hope you enjoyed this post. I've been working on this puzzle for nearly a week. I experienced more than a few "Aha!" moments while doing it.
Source Data:
FRB: Flow of Funds
16 comments:
Wowza Mark! This is really good work! Very interesting indeed. I will have to review it tomorrow and think on it a bit.
The Carthage thing was:
Carthago delenda est
Mark - superb.
Btw, your conclusion (bubble since 1997) absolutely fits the facts.
This is why I blog about this stuff. It is not true that only the nomenklatura can comprehend or work with these facts. The in-group has been sunk in a depressing level of internally-generated fallacy for over a decade.
FWIW, the income trend lines fit in as generating factors.
GYSC & MOM,
I appreciate the kind words.
What really inspired me to do this were the comments I kept hearing regarding China's real estate market. I kept reading stories that it couldn't be in a bubble because people were paying with cash.
I don't think it takes credit to make a bubble though. All it takes is the price of a widget to greatly exceed the cost to make a widget. It inspires widget makers to create an exponentially increasing supply of widgets. Eventually supply will exceed demand.
I therefore tried applying that theory to our own housing bubble just to see what would happen.
The in-group has been sunk in a depressing level of internally-generated fallacy for over a decade.
No joke.
This was an interesting thought experiment. However, I think there's a missing variable that needs to be factored into the equation. That is, quality of construction.
Houses built in the 50s to 70s, for example, were of much sturdier construction. 4x8 oak wood frame, plywood drywalls, hard wood floors, real brick exterior walls, etc. The replacement cost of restoring such a house is considerably higher than that of a recently built home.
In the 90s and the 00s, during the height of the bubble, quality of construction was sacrificed in pursuit of profit. These homes use 2x4 pine wood frame, particle board drywalls, tile or even worse vinyl floors, fake brick exterior walls, ad nauseam. In other words, they're cheap. The replacement cost of one of these homes isn't a third of one of the above.
Just my two cents. The malinvestment in real estate isn't in the real estate per se, but in the improvements on it. I always say, "You want to buy a house cheap? Buy a cheap house." The problem is that a lot of people bought cheap houses at grotesquely inflated prices, with questionable financing. So now the replacement cost, to original construction, is far below what they paid for the house. Which is to say, they could restore the house to its original condition for little expense, and still lose money on the resale, because even pristine it isn't worth what they owe or spent on it.
An older, well-built home in an established neighborhood with good schools, however, is still valuable. In fact, even more so these days.
Yet another jaunt through the wonderful world of real estate.
Still, this was a good article, Mark. I just think you need to tweak the numbers a little to come up with a more accurate valuation chart.
GawainsGhost,
The problem is that a lot of people bought cheap houses at grotesquely inflated prices, with questionable financing. So now the replacement cost, to original construction, is far below what they paid for the house.
You make a great point. It is very easy to overpay for "cheap" goods. I once bought a very "cheap" blanket when my bird was sick. I was amazed how much of it appeared in the dryer's lint trap after every wash.
Gawains knows more about real estate than any of us, so I defer to his input.
Mark,
seriously this is really top flight; my only issue looking at the dataq is that we are near trend line yet home prices have far to fall. Overshoot to the lower end?
GYSC,
I'll go one further. In order for this analysis to work into the distant future we'd have to assume that things all return to normal.
I think that would require a never ending illusion of prosperity and a complete economic disconnect. ;)
Check out the durable goods chart in my next post to see why I don't think that will happen.
eloquent!
Can you help me?
The link to the FRB seems to show replacement costs going back to 2005; how did you get the data (in the first chart) from 1952 to 2005?
In the second chart, the data dots are connected; are they in time order? Is the leftmost dot the from 1952, the one next to it from 1953? And the last one (after going around the hairpin turn) from 2009?
Thanks
-jus me
jus me,
Sorry for not replying sooner.
You have to download the data as found here.
http://www.federalreserve.gov/releases/z1/Current/data.htm
Look for btabs.zip (117 KB ZIP).
You also need the coded tables to make sense of the data.
http://www.federalreserve.gov/releases/z1/Current/Coded/
Look for Balance sheet tables (20 KB PDF).
jus me,
"In the second chart, the data dots are connected; are they in time order? Is the leftmost dot the from 1952, the one next to it from 1953? And the last one (after going around the hairpin turn) from 2009?"
Yes.
Thank you Mark.
- jus me
Mark - looking at chart 1, around 1996, it appears that the ratio dips below the 1.45 average.
Looking at chart 2, I can't find where 1996 point is. Wouldn't it be below the red line?
Is the chart 2 1996 point the squiggle that goes below the red line around the $8 trillion X-axis mark?
Thanks
- jus me
jus me,
It's certainly tough to line up the two charts, thanks to one being on a time scale and the other being on a dollar scale.
It's actually the $6.5 trillion dip you are looking at (on the x-axis).
The ratio hit a local minimum of 1.435 in the 1st quarter of 1997. At that time the replacement cost value of structures was $6.533 trillion and the value of real estate market price was $9.372 trillion.
Here's the amusing/lucky part, at least to me.
The 1st quarter of 1997 was actually when I bought my one and only house. I'm still living in it. Go figure!
Mark, very interesting.
So there's a huge acceleration in total market value from late 1990's to ~2008, which is not surprising. But there's an approximately equal acceleration in replacement costs over the same period.
The replacement cost increase is pretty surprising to me, I wonder why costs went up so much?
The market value increase I thought was due to fancy financing, but the replacement cost increase? No idea.
Thank you for your thoughtful posts.
-jus me
jus me,
The replacement cost increase is pretty surprising to me, I wonder why costs went up so much?
I'm thinking that maybe the replacement costs of the structures was somewhat tied to the prices builders were selling new homes at.
If my home was to burn down at the peak of the real estate market, it probably would have cost me a lot more to get it rebuilt.
Just a thought.
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