This time is different

House prices have been soaring lately. Stock prices reached new highs as this was written (earlier in April). Are these bubbles?

If you go by the ratio of property prices to rents or stock prices to dividends, one would say “yes.” But there is the possibility of inflation to take into account.

If a condo rents that rents for $2000 a month sells for $1 million, that is a ridiculously high sale price. But suppose that after a decade of inflation, the rent is $20,000 a month. Then even if the price/rent ratio drops by 80 percent, the nominal sales price will still be $2 million. So the price will have doubled. If you are looking for an inflation hedge, real estate is a legitimate candidate.* In the long run, so are stocks.

*In this example, the price does not keep up with inflation. But it’s hard to find assets that will exactly keep up with inflation. Inflation-indexed bonds do so in theory–but not if official measures of inflation are slow to capture actual inflation and/or the issuer ends up defaulting on them.

So I would not advise you to short stocks or real estate today (you can short real estate by being a renter and putting your savings into ordinary bonds). You might come out ahead, but not if inflation really takes off.

I do not subscribe to strong market efficiency. I believe that there are times when can call “bubble” and be correct. But not now. Because of inflation risk, when it comes to stocks and real estate, This Time is Different.

14 thoughts on “This time is different

  1. We can observe market estimates of inflation – currently 2.24% for 30 years. We can also observe forward SPX dividend futures- quite flat all the way out to 2031. These moves are all valuation – cash continues to slosh around with limited flow through to the “real economy.”

  2. On new house prices one wonders whether lumber prices are creating a short term price spike or whether this is a longer term phenomenon.

    According to various accounts demand for lumber increased greatly with lockdown home improvement projects and the Texas freeze shut down an industrial resins plant that supplied much of the plywood industry. Will new house prices moderate when these short term impacts fade?

    The 6×6’s I am using in my home improvement project cost twice what I paid last year for them.

    • Longer term, the jihad on single family residential and safe and pleasant neighborhoods will erase trillions in home equity.

    • There is a supply story in the short term, but long run most of the cost of new construction is land and regulation not materials or labor.

      • I am glad that you used “regulation.” Permits and code compliance add costs, in some places much more than zoning.

  3. If inflation pushes up mortgage rates that may harm house prices.

    For many people the 30 year mortgage in a ZIRP environment basically turns principal payments into a non entity. The only thing that effects the payment is the interest rate. Going from say 3% to 6% is going to raise your payment 40%, and since that is the limiting factor on most peoples bids for real estate that is going to have a big effect.

    Really, you want inflation to outpace rates, high rates and high inflation doesn’t necessarily help you. Negative real rates is good for housing just like every other asset.

    • If you are borrowing $1M with a 3% 30yr and consider the principal just a form of saving – investing in your real estate equity – then the real bite is Interest, Property Tax, and Insurance after tax deductions. Assuming about an average 20% income tax rate, the net loss from that first payment is only $2,800 a month, which is about a third of a $100K joint income. Not too far from where I live, that’s how a couple of young teachers I know own a million dollar home with a VA loan. It means they have a very high saving rate vs their peers, but being otherwise frugal, they are able to get by.

      At 6%, “the bite” goes up to $4,800, over 70% more. Spending the same amount on “the bite” means the price could only be $583K, a nominal drop of 42%.

      Even if they expected wage inflation to be high in the future, and so their ability to pay the fixed monthly payment would quickly improve over time, like most people, they still wouldn’t be able to afford the cash payments out of their income in the short term, and so they could only offer a much lower price.

      Now, that is math reality, but I think by this point we all understand quite well, that in political reality, that will never be allowed to happen as a new equilibrium, no matter what else happens to inflation, wages, and interest rates. The current political class would prefer a major war or even another pandemic as opposed to significant and stable correction in house prices.

      That raises the always-fascinating question of how to reconcile bad politics and good math, being fundamentally incompatible versions of reality.

      I think the answer boils down to even more huge and distorting subsidies for mortgages, buying all MBS in sight, and underwriting and regulation being a total joke again.

      • I think that the big thing here is that while you can come up with some complicated model as to how wage inflation is going to make the payment super affordable over the next 30 years, the bottom line for everyone is, “can I afford this monthly payment amount today.”

        The the big determinate of that is the current interest rate, the nominal value of the house not even being that important since the principal is spaced out over 30 years and you will probably just sell eventually anyway.

        P.S. The other day I noticed something I find even more amazing. People will give you a lump sum with no payment if they are assured a % stake in your house when it sells. The really catch to me though is that if it doesn’t sell in the next 10 years they ask for a return payment based some kind of assessment of the value, which is pretty shady and the cash flow don’t line up. So it only makes sense for people that are thinking of leaving.

  4. I am not buying (no pun) your example.

    You have two identical condos next to each other. You have stash of cash.

    In one case, you rent for $2,000 per month. Nominal rent rises with CPI but real rent stays the same. You put the cash into a bank account, and draw it down to pay the rent.

    In the other case, you buy the condo for $1,000,000 with cash. Your stash is gone, but you have no rent or mortgage payments.

    You pay the same utilities in both cases. Make this easy, and ignore insurance and property taxes.

    What do interest rates have to be to make $1,000,000 a good deal?

    Put it another way, if you were an investor, would you pay $1,000,000 to get a sure rental payment of $2,000 per month?

  5. A inflection point will be what happens in about 4-6 months when the last of the 1.9 trillion dollar of stimulus has dribbled out into the retail sector. There is, of course, the “infrastructure” bill still to come, but that looks to have no direct checks to the populace in it, but that will also peter out within a year’s time.

    At some point in the future- 2022 or 2023, the economic statistics will be affected by the fact that there isn’t a second dose of 8 trillion dollars in additional government spending coming down the pipeline- or the economic statistics will be affected by the fact that the 8 trillion dollars will be recurrent factor that has to grow with time.

  6. Theoretically this post makes sense, but empirically it doesn’t. The Case Shiller index for 1970 was 137.06, in 1980 it was 139.53. Even cherry picking the best return starting in 1970 takes you to 1978 and a 148.29 reading- an 8.2% nominal return over 9 years in a high inflation environment.

    The C/S index bottomed in 2012, between then and Feb 2020 it went up ~60%, since then it has gone up another 11%. This was not a high inflation environment from 2012-2020 and while the price action for the past year has broken trend to the upside by a good amount it isn’t directionally different.

    • When prices are rising, maybe there is a “weighted average” inflation rate, but there is also a dispersion factor.

      Of course, one expects there to be *some* volatility and variation – for some prices to go up more than others – but the question is how spread out they are. If most prices rise in sync, close to that average, that seems like classic ‘price level inflation’. If we only get to an average low rate because some important prices are declining or even collapsing (e.g., some IT-related prices) while others are exploding, then that seems like a qualitatively different situation. It’s not easy to compare to past contexts, and hard to know how it’s all going to shake out.

      • Does the Cantillon effect ironically cause prices to rise faster and further the closer you are to the Regime? Luckily this happens only after the politically favoured spend the money, but…

  7. All real assets are perfect inflation hedges. This includes stocks and real estate, in the short and long run. Inflation expectations impact the relative price of real assets and nominal assets, not the relative prices among real assets. If housing prices rise more than other real asset prices, then it means either that the supply/demand outlook for houses is more bullish, or (by definition) that the price rise is a bubble.
    The analysis is slightly different if housing has a nominal element e.g. nominal rents are sticky.

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