One of my economics heroes, Robert Shiller whose work I have admired (but not always agreed with) wrote a provocative commentary on “Booms” in the Wall Street Journal last week called, interestingly enough: Things That Go Boom [WSJ].

We shouldn’t blame these people for not seeing the boom coming. Nobody did. But those economists who say today that the real estate boom has been justified by “fundamentals” have to explain why they weren’t able to forecast the high home prices we have today based on those fundamentals.

With the failure of anyone really to predict today’s high home prices, one may well conclude that no one can predict today whether a home-price bust is coming, or whether the housing market will land softly, or even is poised to resume its upward climb. That may be the right conclusion about our ability to forecast the markets.

On the other hand, there is another perspective on this colossal failure to predict. Maybe it doesn’t mean that no one can forecast, but instead that the high home prices today are just an enormous anomaly that will have to correct downward sometime, if not right away.

Basically, the premise in his piece is the idea that fundamentals didn’t help us predict the housing boom to the extent that it occurred, which means that fundamentals can’t tell us whether we will have a hard or soft landing either.

Can anyone define what housing fundamentals actually are? The term is always used rather loosely and infers strenuous economic consideration. How about: Employment? Housing Starts? Inventory? Mortgage Rates? GDP? Its seems to me that the list is subject to debate, and the assumption that fundamentals are solid is based on a list that is not universally agreed as fundamental.

Professor Shiller was the creator of the housing index used as the basis for trading on the Chicago Mercantile Exchange last May, which has been characterized as garnering very little interest by investors.


Perhaps the lackluster interest is because it doesn’t include all elements of the housing market including new home sales (a significant factor) and foreclosures (a rising factor). The index predicts price declines in 10 major markets that are currently being covered but it seems like the same sort of experience (in reverse) made by individual investors who could do no wrong in the late 1990’s because every stock was going up.

I lost interest in following the CME price patterns because of the low trading volume. The volume in specific markets seems to be more of the story these days than the reliability of the pricing.

We are left with a deeply uncertain situation, but one in which it would seem that a sequence of price declines continuing for many years has some substantial probability of happening. Traditional finance theory has trouble reconciling even a semi-predictable sequence of price declines with basic notions of market efficiency. The situation we are facing is a reminder of the glaring inefficiencies and incompleteness of existing markets for residential real estate, and may be regarded as evidence that institutional changes will be coming in future years to fundamentally change the nature of these markets.

It doesn’t seem like anyone has a handle of the direction of macro real estate markets at the moment, beyond relying on conventional wisdom. Professor Shiller seems to be moving away, if just a little, from the position that indexes can be used to accurately predict real estate markets, despite his groundbreaking work in this area. He seems to be moving toward the conventional wisdom argument what comes up must come down.


5 Responses to “Housing Fundamentals Go Boom!”

  1. skep-tic says:

    while there may be disagreement as to a complete set of housing fundamentals, there are certainly a few basic fundamentals that almost no one disagrees with

    I think Shiller’s bigger point is that fundamentals have limited predictive value in a market as inefficient as residential RE.

    Take for examples the issue of transaction costs. Houses are hard to sell and involve lots of intermediaries.

    The difficulty and expense of selling houses clouds our picture of house prices vs rents (a fundamental) because entering a lease is a far simpler and cheaper process than transferring title.

  2. WT Economist says:

    (Can anyone define what housing fundamentals actually are?)

    People’s income. With investment properties, the fundamental is those properties income, which is used to support the purchase price. For housing, it is the people’s income.

    Lower interest rates help the same income support more housing. In a bubble, people will stretch and stretch, worried prices will rise further if they do not. Lenders will stretch and stretch. But ultimately, they can only stretch so far before they can’t make the payments and live a decent life.

    And once prices stop rising, people will decide they don’t want to stretch anymore. Unless rising rents force them to.

    The fundamentals are people’s income, and the relative cost of renting and owning.

    Now maybe in Manhattan you can imagine a market supported entirely by hedge fund traders and multi-national millionaires buying pied-a-terres. But that won’t work for the whole metro, or the whole country.

  3. Fritz says:

    Yes, to agree with Jonathan, the investor interest in the CME housing futures has been low and lackluster. Maybe the market at large is looking at the indices and the futures contracts as all things to all people. In other words, can we use the futures to “hedge” a particular housing asset? I think not – too much basis risk. Are the contracts good for taking strategic and tactical views on the US housing market? I think so. Do we need maybe other contracts that trade alongside price housing contracts and reflect tipping points in the housing market? Maybe, like forwards on Existing+New Housing Sales or Housing Starts… these metrics reflect immediate changes to the fundamental underpinnings of the housing market. Further, they help to mitigate the economic damage that results from housing sales liquidity loss.

    There are investors interested in the success of the CME housing futures – they have been lobbying for extended year listings to the futures contracts. Out to five years. That would mean the professional capital markets has the ability to take a view on US housing prices into 2012.

    And one can argue that the futures market does not “predict” the direction of prices – more perhaps that the futures prices reflect the collective position taking of the market at any one time. For example, the one year forward futures market for most of the cities in October 2006 was discounted 6%-8%; now, the one year forward view is down 2%-3%.

  4. Shiller has never said that prices are about to fall. Just that they are high and should fall some time. It is worth noting that his stock market bubble analysis was very early.

    Fundamentals matter (and the ones mentioned are a good start) but they can’t tell you the “right” price with any precision.

    I think Shiller’s main point is that prices can deviate substantially from the fundamentals and that they have. That doesn’t mean they will return to more sensible values any time soon. But that the potential is there that they might and some day they will.

    I think one of the underpinings of this home price rally has been easily available credit that APPEARED to be cheap because of teaser rates and other artificially low payment requirements of many mortgages. This was sustained by the fact that borrowers were able to refinance into new (low-payment mortgages) because prices kept rising. That process now appears to have stopped and there will be a lot of pain on the part of sub-prime borrowers, lenders and those they passed the risk on to. I can’t say whether this will be broad enough to affect the market as a whole but I wouldn’t rule it out.