Are we there yet?

The U.S. housing market has recently shown signs of recovery. Is this the real thing or just a blip on a chart?

By Robert Shiller

 

Home prices showed a sharp turnaround in the last few months. The S&P/Case-Shiller 10-City Composite Home Price Index bottomed out in April 2009 and since then has increased for three months in a row, according to the most recent available data. This comes after declining every single month for nearly three years. The increase in home prices, which can be seen in the figure below, does not look very big, and prices are up still only 3.6 percent. But it looks a lot like a pretty sharp turnaround in home prices, given the way home prices have been behaving. Of course, people who deal regularly in speculative markets will doubt that any sudden turn in the market can be very meaningful about the future. Most speculative prices are approximate random walks, and so extrapolating new trends is risky business.

But remember that the market for single family homes is extremely inefficient, trendy like no other market. That is because the market for single family homes is populated mainly by ordinary people, not investment professionals. These ordinary people do not trade in and out of this market on a dime to exploit emerging trends. Instead, they are often holding on to their investment in a down market, continually losing money over a period of years in a futile hope for a rebound. Then they may hold on too long in an up market.

Investment professionals find it very difficult to trade in single family homes directly, because transaction costs are so high. Moreover, dispersed single family homes are difficult for large-scale investors to manage properly. Supervising the maintenance of these properties – if they are held for any length of time – is challenging. Moreover, the government gives tax breaks to homeowners, in the form of tax-free imputed rent on the house they live in and capital gains tax breaks on resale, which are not available to professional investors. So, professionals stay almost completely out of the single family home market.

Futures on the S&P/Case-Shiller 10-City Composite Home Price Index are traded at CME Group and provide an efficient means for investment professionals to trade the single family home market. In addition, creating a liquid market for an index of home prices, alongside the illiquid cash market, would set in motion a process that would eventually make the cash market for owner-occupied homes more efficient. At this point, the futures market has not yet come along enough to have any such effect. Thus, it is no surprise that the home price market shows such momentum. In the past, it has usually been smart to assume that a good part of any recent trend will continue in future home prices.

The question then is, can we really extrapolate this new trend, and expect the housing market to continue to increase? Indeed, the markets have reacted to the increase in home prices this way. Housing MacroShares Up (ticker symbol UMM) and Down (ticker symbol DMM), developed by the firm I co-founded, MacroMarkets LLC, began trading on the New York Stock Exchange on June 30, 2009. As a nascent cash market supported by market makers, and with prices updated every 15 seconds, these securities are complementary to CME Group housing futures, giving individual and institutional investors the ability to invest in or hedge single family housing via the stock exchange. These Housing MacroShares have a November 2014 maturity date, and underlying values based upon three times the cumulative change in the S&P/Case-Shiller 10-City Composite Home Price Index from the initial index level of the securities. The price of UMM has doubled in the last three months, as optimistic data and news reports concerning home prices have surfaced. That suggests that the news about the upturn in the housing market was taken very seriously by the market.

 

The next block over

But, there are substantial reasons to reserve judgment about the outlook for home prices. The simplest is that the new trend is only three months old. The forecasting models that Karl Case and I developed 20 years ago, and used to predict home prices in the 1990s, would not make a great deal of just a few months' increases. Moreover, in an historical context, the suddenness of the upturn in home prices looks suspicious as such sudden turnarounds have practically never happened before.

With a very high fraction of home sales now being distressed sales, with foreclosures continuing unabated, with the federal tax rebate for first time home buyers due to conclude at the end of November, and the planned gradual phase out of the Federal Reserve's $1.25 trillion mortgage-backed securities purchase program, there are plenty of reasons to worry that home prices that are quoted are not really normal, and that they might turn down again.

After the last major real estate boom, which ended with the recession of 1990 to 1991, there was no sudden rebound in home prices. One can see in the figure a slight upturn from April to September 1991, just at the end of the home price drops, amounting to about a 2 percent increase. This little 1991 rebound looks almost like the rebound we have just seen. But it fizzled. Indeed, home prices languished for years after 1991, and did not show signs of life again until near the end of the century.

 

Know your neighbor

What has tended to happen in previous cycles reflects human behavior that is inherently speculative, if not professionally so. People hold out on selling, continuing to await higher prices, but there is no substantial force to bring on those higher prices. Their ideas about how much housing to occupy change very slowly. When thinking non-speculatively about housing, they are contemplating whether they need a larger house with an extra bedroom, or whether they need a house at all. And they are thinking about how they will live through the rest of this economic crisis, which may drag on for years for all we know. They are making lifestyle choices that they expect to live with for years to come, and such decisions tend to move them only over years, not months.

So the uptick in home prices that we have seen in the last three months presents an enigma that no statistical analysis of historical data can resolve. This increase may ultimately be speculative, not substantive. Or, it may represent a resurgence of animal spirits that will mark a real revival. Only time will tell.

The future of both outsized returns and best-of-breed risk management should go one step further. Traders should systematically incorporate the idea of a social markets hypothesis into their approaches. Strategically magnifying the focus on the foundational question will expand the universe of strategies and risk management options by an order of magnitude that no mere chip-set can reach.

Robert Shiller is the Arthur M. Okun Professor of Economics and Professor of Finance at Yale University, and chief economist at MacroMarkets LLC. He serves on CME Group's Competitive Markets Advisory Council.

 

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