Monday, May 22, 2017

What caused the last US housing bubble

There is still no consensus on why the last housing boom and bust happened. That is troubling, because that violent housing cycle helped to produce the Great Recession and financial crisis of 2007 to 2009. We need to understand it all if we are going to be able to avoid ordeals like that in the future.

But the explanations for what happened in housing are not, I think, to be found in the conventional data favored by economists but rather in sociologically important narratives — like tales of getting rich through “flipping” houses and shares of initial public offerings — that constitute the shifting mentality of the era.

Consider the data for a moment. It shows us that extreme changes took place but doesn’t tell us why.

Real home prices rose 75 percent from February 1997 to December 2005, according to the S&P/Case-Shiller National Home Price Index, corrected for inflation by the Consumer Price Index. And then, from 2005 to 2012, real prices reversed course, falling to just 12 percent above their 1997 level. In the years since 2012, they have climbed 29 percent, about halfway back to their 2005 peak. This is a roller coaster in national home prices — it has been even scarier in some more volatile cities — yet we have no clarity on why it happened.

The problem for economists is that these changes don’t correspond to movements in the usual suspects: interest rates, building costs, population or rents. The Consumer Price Index for Rent of Primary Residence, compiled by the United States Bureau of Labor Statistics and corrected for inflation, went up only 8 percent in 1997 to 2005, so unmet demand for housing services can’t explain the huge increase in real home prices. It doesn’t explain the 29 percent rise in real home prices since 2012 either, because inflation-adjusted rents increased only 10 percent in that period. So what has been driving the wild ride in home prices?

I believe the price swings have something to do with the changing mentality of the times, changes caused by narratives that have gone viral and swept across the population. Looking for answers in such popular stories contrasts starkly with the prominent approach of modeling people as though they react logically to economic forces. But a less orthodox approach can be quite useful.

One thing is clear: The prevalent narratives of 1997 to 2005 did not include the concept of a housing bubble, not at first. A computer search using ProQuest or Google Ngrams shows that the phrase “housing bubble” was hardly used until 2005, the end of the boom. What is a bubble? It typically includes the notion that, spurred by the public’s expectation of ever further price increases, demand eventually reaches levels that cannot be sustained, and so the enthusiasm wanes and the bubble collapses. But that thought was just not on many people’s minds then, the evidence suggests.

Instead, during the 1997 to 2005 boom there were multitudes of narratives about smart investors who were bold enough to take a position in the market. To single out one strand, recall the stories of flippers who would buy a house, fix it up, and resell it within months at a huge profit. These stories appear to have been broadly exciting to people who didn’t flip houses themselves but who appear to have begun to think that stretching a little and buying a house with a large mortgage would make them wise investors.

In his book “The Complete Guide to Flipping Properties,” published in 2004, Steve Berges extolled what he called “the O.P.M. principle,” meaning “other people’s money.” He wrote, “Your objective is to control as much real estate as possible while using as little of your own capital as possible.” In other words, borrow as much as you can. He wrote about the upside of leverage but not about the perils of leverage during the kind of big price drops that were just around the corner.

It can take a long time for narratives like this to grip the popular imagination. Flipping was “a thing” in the condominium conversion boom of the 1970s and ’80s. The idea then was this: Big-time converters with deep pockets would buy apartment buildings and convert the rental apartments to owner-occupied condos, selling units to diverse individuals, some of them flippers. For public relations purposes, converters would offer to sell at reduced prices to renters already living in a building, and typically to some outsiders, too.

This generated buzz. When renters and speculators flipped their purchase contracts at a big profit, sometimes using borrowed money for down payments to flip multiple units without actually even closing on the condos, it was thrilling. It seemed that anyone with energy and initiative could get rich doing this.

Some people eager to make quick profits bought Donald J. Trump’s well-timed 2004 book, “Trump: Think Like a Billionaire: Everything You Need to Know About Success, Real Estate, and Life,” written with Meredith McIver. Some enrolled in the less well-timed Trump University, which emphasized real estate investment in 2005, at the very end of the housing boom; it shut down, amid lawsuits and recrimination, in 2010.

Narratives about flipping weren’t restricted to real estate. Just after the time of the condo boom, stories of rapid buying and selling of initial public offerings took off as well. As with the condo promoters, I.P.O. underwriters would sell some shares below market prices to customers, who might then flip the I.P.O. for a quick profit.

The promoters of condo conversions and I.P.O.s were onto something. By giving discounts to buyers who would make a high return, they captivated the nation with tales of people who had no advanced degrees or hefty résumés but made fortunes anyway.

By now, the notion of getting rich by flipping houses is entrenched. I searched Amazon for books on “flipping houses” and came up with 328 hits, most written in the past few years. Buying and rehabbing existing houses for resale is a legitimate business. But many of these books make extravagant pitches and seem aimed at inspiring amateurs to plunge into risky ventures.

The public fascination with speculating in housing has been held in check by regulators empowered by the 2010 Dodd-Frank Act, but that restraint is tenuous with the election as president of a real estate promoter intent on reducing regulators’ power. These narratives are still potent and could easily spur further spirals in the housing market.

Tuesday, May 2, 2017

The recession was a consumer boycott

Robert Shiller, in a discussion paper few months ago, laid out the argument for economists paying closer attention to the "narratives" surrounding economics. To Shiller, popular narratives drive more of the fundamental economic outcomes than economists are typically willing to admit.

For example (one provided by Shiller), the 1921 recession following the end of World War I was, in part, driven by narrative. In contrast to the typical explanation of why it occurred (a central banker went on a long vacation), there are more fundamental reasons for the downturn, including a 50% increase in the price of oil (with wide-spread fear that oil production would peak in a few years) and-probably the most important-deflation expectations. Because consumers believed that prices would fall, they held back from making purchases.

This was the era of the "profiteer", the word used to describe price gouging. Thrift became a virtue, and there were calls to avoid buying anything other than the essentials. Consumer spending plummetted, leading Shiller to describe the recession as a "consumer boycott" lead by narrative, not by a traditional business cycle.

While the example above is buried deep in history, there is applicability to the present. Specifically, the rise in central bank communications. There have never been more speeches given by representatives of central banks than today. In a recent speech given by the Chief Economist of the Bank of England Andrew Haldane,  he calls for less complex and more accessible communication of monetary policy. Ostensibly, this is to increase transparency and trust with the public and describe their actions and intentions to markets.

Being clear and transparent about the goals and sought after outcomes is a legitimate strategy being pursued by central banks around the world, the "forward guidance" policy tool. That is meant to build trust and utilize that trust to instruct outcomes. In some ways, build and maintain a narrative of economic conditions.

This is where it becomes interesting for modern central bankers.

First, it is not quite that simple to construct a narrative. Note that the accessibility of monetary policy is low. The primary piece of material used by the Fed to communicate its strategy, the FOMC minutes, has an exceedingly low accessibility. This makes the communication outside of it far more important to the broader public and the maintenance of a given narrative.

Second, while the Fed (or other central banks) may wish to control the economic narrative, it may not be capable of doing so. Narratives, as pointed out by Shiller, have a life of their own.

What does this have to do with anything? One of the critical elements embedded within both the "narrative economics" theory and "forward guidance" is that the ability to avoid a repeat of a 1921 style, narrative driven retreat. It also shines a light on the need to carefully deconstruct popular narratives for their potential economic consequences. Further, it points to the potential consequences of shifts in the efficacy of forward guidance from central banks.

Thursday, April 27, 2017

You should own European stocks

We're living in very volatile times. We don't know what to expect.

Most Americans are not well-diversified globally. When we're talking about the 'Trump effect,' that is primarily a U.S. effect. You can solve that problem by diversifying around the world.

Europe should be a big thing in one's portfolio. Their price-to-earnings ratios are much lower. It looks bad because they've been through troubles recently. But people sometimes exaggerate those troubles.

We have a lot of bad narratives about Europe. But you have to think back at the long history. Europe has done quite well.

Sunday, April 2, 2017

High CAPE ratio making me nervous

It's already high enough to make me nervous ... the CAPE ratio is one of the best indicators, or I might say the best indicator, if you look at one alone, for the outlook in the long run for stocks. It's high now; and in the past when it's been this high, it hasn't done well.

I'm just playing the game a little bit here, and thinking, in the shorter run, this rally — I can start to see reasons for it, and I'm thinking about those reasons.

This is not a typical bull market with a lot of excitement. It's more of an anxious market where people are afraid of secular stagnation, of losing their jobs to foreigners, or to computers. And they have kind of a wishful-thinking bias about investments like stocks. It's the only way I can understand it. 

I'm not going to plunge into the market. I'm holding steady; I'm not pulling out, either. If I was giving you advice: Do nothing. Don't pull out. Don't go in," the Nobel laureate economist said Tuesday. "I'm sounding very standard right now. I still suspect there is more left in the Trump rally. 

Monday, March 20, 2017

Long term investors could reduce risks by selling some stocks

Long-term investors ought to use the recent market rally to cut back on their equity holdings, according to Yale professor of economics Robert Shiller.

The S&P 500 forward price-earnings ratio, a common measure of market valuations that compares the index's current price to analysts' consensus expectation for earnings over the next year, is now at the highest level since 2004, according to information from S&P Global.

The cyclically adjusted price-earnings (or CAPE) ratio developed by Shiller shows even greater overvaluation; that metric, which compares current prices to average earnings over the past 10 years adjusted for inflation, is more elevated than it's been since 2002.

The CAPE ratio, which aims to measure earnings over the course of an entire business cycle, is "high enough to worry about," Shiller said Thursday on CNBC's "Trading Nation." "At this level, it suggests that the expected returns for stocks might be negative, but only slightly so."

Shiller is quick to add that since short-term moves are nigh impossible to forecast, the metric "is not suggesting, necessarily, any imminent disaster."

Still, the current level of the CAPE ratio "would suggest reducing your holdings of stocks, especially for a long-term investor. We can't time the market accurately, but we know that when it's this high, over the long term, it usually doesn't do great."

Thursday, February 16, 2017