Shambling Towards Affordability: San Diego Housing Overpriced (But is it a Bubble?)

I must admit, I considered dispensing with the “Shambling Towards
Affordability” title for these valuation updates, but in the end I
decided that tradition must be maintained.  Anyway, other than
the fact that the housing market is neither “shambling” nor moving
“towards affordability,” it’s a perfect fit.

One thing I did change was to combine my two previous valuation
indicators, home-prices-to-incomes and home-prices-to-rents, into a
single metric.  I thought this would make it simpler to get a
single big-picture view on home valuations, and it makes the chart
maintenance a little easier on me as well.  The indicator is
constructed simply by dividing the Case-Shiller San Diego home price
index by an equally weighted average of San Diego rents and per
capita incomes, and normalizing the whole deal so that January 2000
equals a value of 100 (just like the CS index). 

OK, enough background… let’s have a look:

Despite the recent runup, San Diego housing valuations are still
dramatically lower they were during the bubble.  However, homes
are far from cheap — at 12% above the historical median valuation
(down from a recent high of 13%), housing has become nearly as
expensive as it got during the 1979 and 1990 peaks.

This isn’t a very big sample set, but for what it’s worth, here’s
what happened each of the last three times housing valuations rose
to this level:

• Late 1970s –Valuations rose just a bit further, then fell
  into a multi-year decline.  Nominal prices actually rose
  slightly during this period, but valuations dropped as high
  inflation drove up incomes and rents.
• Late 1980s — Once again, valuations rose a bit further then
  declined for the better part of a decade.  This time, there
  was an actual decline in nominal home prices of 17% per the CS
  index.  Meanwhile, rents and incomes rose, further reducing
  valuations.
• Early 2000s — Valuations exploded upward during what became a
  monumental bubble, eventually (many years later) crashing back
  down below the historical median.

So here we are at this level once again.  What will happen
next?  Here are a few reasons why I don’t think that’s
knowable.

• Again, small data set.  I only have data on three prior
  cycles, not enough to draw general conclusions from.
• The first two times during the data set that we reached this
  level, we saw big valuation declines.  But that doesn’t
  mean that valuations magically decline once you hit this
  level.  The 1990s bust was exacerbated by a pretty bad
  local recession, and the early-80s valuation decline coincided
  with both a serious recession and extremely high mortgage
  rates.  In other words, the outcome from here is partly
  dependent on what happens in the real world.  (That said,
  housing’s high valuation puts it in a vulnerable situation, as a
  positive economic outcome already appears to be “priced in”).
• And then we have that pesky little incidence in which
  valuations reached these levels, just started to falter, and
  then flung up to previously undreamt-of heights.  The
  primary fuel for the housing bubble was an overly accommodative
  central bank that was providing excess liquidity in an attempt
  to mop up after that prior bubble… sound familiar?
• I’ve used the historical median as a baseline for comparison,
  but it’s entirely possible that the sustainable level of “fair
  value” pricing could creep up over time.  That can only
  really be known in retrospect.
• And then, of course, we have interest rates.  This chart
  shows how monthly payments stack up against rents and incomes:

Despite last year’s move up — a result of both rising prices and a
jump in mortgage rates — this chart shows that monthly payments are
still very much on the low side of history.  For as long as
that continues to be the case, it could allow valuations to “float”
up above normal levels.  When it changes, though, that will
remove a major tailwind for housing valuations.  (And, that
really does seem to be a “when,” not an “if,” because rates are only
as low as they are due to central bank intervention that must end at
some point… as to when, that’s anybody’s guess.).

Interesting side note: last year’s move up in the monthly payment
index appears pretty minor on the scale of this chart, but it was gigantic
in relative terms, increasing by 34% in just fourteen months! 
That is a major (relative) hit to affordability, but it’s not
readily apparent on the chart because we started at such low levels.

Anyway, you can see why I think there are many reasons that it’s
tough to know with any certainty what will happen with home prices
and valuations.  But we do know this: homes are more expensive
than their typical historical level, and valuations are at levels
that, when previously reached during our admittedly limited data
set, always eventually returned to (and through) the median
valuation.

Shorter version: San Diego homes appear to be overpriced. 
Proceed with caution.

Bonus Nerd-Out: Is Housing In a Bubble?

This is a question or proposition I’ve heard a lot… in fact, there
is an active forum
thread addressing this topic right now.

For what it’s worth, I don’t actually think it’s all that meaningful
to contemplate.  The important thing to understand is whether
something is overpriced, and by how much.  The question of
whether it is a “bubble” is mostly a matter of semantics, and is
based on one’s own definition of a “bubble,” which can obviously
vary from person to person.

But just for fun, let’s try to figure it out. 

I’ll start with the definition.  To me, the defining feature of
a bubble is extreme overvaluation.  Investor enthusiasm and
rapid price changes can certainly figure into it, but if something’s
not really overpriced compared to the fundamentals, it’s not a
bubble. 

So how overpriced is overpriced enough?  For this, I will defer
to the really smart folks at GMO, an investment management firm that
has done a ton of research on historical investment bubbles. 
They have a purely quantitative definition of a bubble: when an
asset’s valuation reaches 2 standard deviations above its historical
fair value trend.  Such an occurrence should be, and has been,
a very rare event.  And very interestingly, almost all of the
major bubbles they’ve studied (36, if memory serves) have eventually
“popped,” aka, come back down to their fair value.  (The only
ones that haven’t popped are still ongoing, so the jury is still out
on those.  But the conclusion is still that bubble almost
always — or, maybe, always — burst).

The red line in the graph below shows what the threshold would be
for a bubble in San Diego housing:

While we reached, and handily surpassed, bubble status in the
mid-2000s, clearly we are nowhere close just now. 

Some might argue that the bubble itself distorted this definition:
if we hadn’t had the mid-2000s bubble, the standard deviation of the
valuation series would be a lot lower, and the bubble threshold
would accordingly be lower as well.  Now, this is certainly an
interesting point, but I don’t feel that it’s a good idea to start
cherry-picking which data you use, as this kind of defeats the
purpose of using a quantitative, unbiased definition. 
Nonetheless — just for curiosity’s sake — here’s what the bubble
threshold would look like if we only based it on pre-2003 data (2003
having been picked somewhat arbitrarily as the year when SD housing
really started to go nuts):

Even by this much less stringent definition (and again, one that I
don’t think is valid, for reasons described in the last paragraph),
we do not meet the bubble criteria.

So, using GMO’s quantitative 2-sigma definition — which is as good
a definition of any I am aware of — this is not a
housing bubble.  For what that’s worth.  (But homes are
still overpriced).