Thursday, December 08, 2005

Reversion Toward The Mean

Will we see a reversion to the mean in housing prices?

Like most people, I believe that markets tend to revert toward the mean. However, the key question is determining the future mean value toward which the market will revert. The market mean shifts with time as the underlying fundamentals evolve. What was a valid mean a few years ago at higher interest rates and lower GDP will no longer hold true today.

Look at some other areas for comparison -- medical expenses have risen faster than GDP and inflation for decades. Must these costs collapse in order to revert to the mean? Not likely. The economics have evolved – the mean value has shifted. How about college tuition, which has increased even faster than medical costs? Will there be a collapse in tuition prices to revert to the mean? No. There are sound economic and demographic reasons for the continued real increase in tuition prices. The mean value has shifted.

People who currently forecast serious housing price declines do so based primarily on the fact that prices have gone up so much, along with easier credit and speculator activity. These are all significant considerations. However, it is not enough to focus on the imbalances that come with the temporary exuberance near the cycle peak. One must also examine the evolving nature of the fundamentals that drive real housing demand. There will be a cyclical decline, but how far depends not only on the current frothiness but also the underlying enduring fundamentals.

While the easy credit and flippers have been getting all the attention, nearly all of the bubble trackers have neglected to look at the shifts that are taking place in our economy and our population.

If you study the demographic profile of our country you would see that the age distributions are such that we are about to experience a significant increase in household formations, and an accelerated shift toward higher average age of the population. The propensity to own goes up with age, as does income and wealth. This means that we will have significant growth of real demand for owner-occupied units in the coming years. So the mean value has been rising underneath this frothy market, and will mitigate the magnitude of the decline.

6 Comments:

At January 27, 2006 6:01 AM, Anonymous Anonymous said...

Sir,

Allow me to paraphrase your arguments regarding mean-reversion and the housing bubble:

1. Historic means can shift over time.

True enough.

2. You assert that college tuition and medical costs have been rising faster than GDP/inflation and are examples of this "mean shift".

The former assertion is true, but not conclusive proof of the latter claim. Perhaps these trends will continue indefintely into the future, and perhaps not. Regardless, any necessary living expense that rises faster than incomes must eventually be counter-balanced by reduced expenditures on other necessities. And when any necessity grows unaffordable for most consumers, they will seek (and generally find) cheaper alternatives.

3. Current real estate demand is being driven by "underlying fundamentals", not speculative excess and easy credit, which has been getting so much attention lately.

Bold claims demand bold proof, sir. Where is yours?

4. We are experiencing a demographic shift towards a "higher average age of the population".

True enough, and...?

5. "The propensity to own goes up with age, as does income and wealth", ergo more housing demand, ergo soft landing for the current bubble.

Bingo --here we go! More false causality, along the lines of your "Is the Sky Falling?" post.

Basically you're making the classic "It's a NEW PARADIGM" argument here, based on the undeniable logic that because the population is getting older, we (a) are all somehow collectively getting wealthier and (b) have a greater "propensity to own" real estate.

Pure nonsense. First of all, it's well established that housing demand ("propensity to own") peaks during household formation/child-bearing years (typically late 20s to mid-30s), not during old age. Baby Boomers are already well past this point.

Secondly, the foolish (and high-risk) game of selling each other bubble-inflated real estate is not likely to make us all collectively richer. On the contrary, it's far more likely to part late-in-the-game participants (suckers) from their money. The inevitable correction might even spawn a severe recession, especially in the most "frothy" markets, as speculative bubbles tend to do.

Again, allow me to recommend a few sites to assist you in obtaining relevant facts and developing more persuasive arguments:

thehousingbubble2.blogspot.com
themessthatgreenspanmade.blogspot.com
calculatedrisk.blogspot.com
piggington.com
patrick.net/wp

 
At January 28, 2006 1:29 AM, Blogger zephyr said...

Anonymous,

You say I am implying a new paradigm in my statements. Actually, I am pointing out the fact that it is NOT a new paradigm. That the forces that have always driven the markets are still in effect – supply and demand. And both do shift over time. That is my point about the shifting mean.

You disagree with the growing wealth point. However, it is a well documented fact that our wealth and income have been generally increasing. It is true that for many (especially the lower incomes) this growth has stopped or slipped in the last few years. However, overall, and particularly among people at the income levels that buy houses, incomes and wealth have been growing - even in recent years.

The propensity to own increases throughout adult life. It peaks shortly after retirement age. You are misinformed to think that homeownership rates peak in the mid 20s and 30s. It is household formation that peaks at those younger ages. But those younger households are mostly renting. They will buy later.

The baby boomers are not finished buying homes. Many have yet to buy their first home, and many are buying vacation and future retirement homes. This will accelerate as their retirement ages approach. At some point many of them will sell their primary homes. Demographics suggest that real housing demand will peak sometime after the year 2025.

 
At January 29, 2006 9:21 PM, Anonymous Anonymous said...

"Demographics suggest that real housing demand will peak sometime after the year 2025."

Zephyr,

There are two parts to housing demand. Demographics which gives a very good age profile of buyers. This I agree with in part agree with from my limited knowledge of my peers. I am young 30's, and of my peers, many of us are "waiting" this one out.

Could you provide the source for these population statistics?

The second major portion is wage growth and security drive house purchasing. This is a major problem in your current reasoning. What long term demographic trends do you see in the US that show improved wage growth?

Again, if you could provide statistics/sources. From my limited personal angle, everyone I know from the dotcom years has abadoned their engineering training and degrees and is now in finance. 1 went into energy trading at a well financed hedge fund. Others are working in lucrative Banking IT positions.

I was the only one to go back for more technical training. In graduate school, more than 50% of the students are foreigners. They come for jobs, but at far reduced salaries to US workers. Also, many of these people go back form businesses, and compete with US companies with 1/6th the wage structure.

Secondly, actual evidence shows significant deflation in wages across the board as the third world brings on higher skilled labor in Manufacturing, Technology. What sectors will survive the deflationary wage pressure? I'm think I'm in one, but let me see if you can identify it.

Fewlesh

 
At January 31, 2006 12:26 AM, Blogger zephyr said...

Fewlesh,

Here is what I expect on a macro level looking forward:

Deflationary wage pressures will affect everyone, but not equally. Those whose jobs can be done anywhere in the world will see the most pressure. In time this will affect higher skilled workers as well. The low skilled are the most easily substituted and have been the first to suffer from cheaper wage competition. We will see a slow but steady globalization of the employment markets and wages.

With this will come lower real costs for goods and services, raising the real incomes and wealth for those who do not lose in this competition. There will be winners and losers, but in the aggregate worldwide per capita real incomes and wealth will rise.

Inflation and deflation are monetary phenomenon, and can be countered or controlled by monetary policy. As such, the global wage competition need not result in deflation, nor declines in asset values.

Looking Back:

On an inflation-adjusted basis household incomes in the US have increased fairly steadily for many decades. Incomes for the two upper income bands have increased substantially, while the middle band has increased modestly.

Here is a link for Household Income Distribution by year in constant 1998 dollars:
http://www.census.gov/hhes/income/
incineq/p60204/p6098tb3.html

Note that real income has increased in every income band over the decades through 1998.

Since this study, there has been some slippage in the middle and lower bands, while the top income bands have accelerated. Housing prices are driven by the upper and middle income bands. Generally, the middle band is the source of first-time buyers, while the upper bands are the trade-up buyers, and second home buyers. The bottom two bands are almost all renters.


But what about the future real demand or real need for housing?

By looking at population distribution by age we can forecast the real housing demand for many years into the future. Here is a graphic display of population by cohort:
http://www.nationmaster.com/
country/us/Age_distribution

Note the steady increase in the forecast of adult population in the coming decades. This is not speculation – the people are already born for the 2020 forecast. If you slice this data carefully and evaluate the propensity to own by age cohort the result is not only a rapid rise in household formations in the next 10 years but also a strong rise in expected homeownership through the next 20 years.

However, none of this precludes cyclical downturns.

For the benefit of housing demographic buffs with insomnia, here is a Census report that gives some interesting perspective on population trends. http://www.census.gov/prod/
2002pubs/censr-4.pdf

 
At January 31, 2006 12:48 AM, Blogger zephyr said...

Fewlish,

The links that I listed above must be retyped to work. However, I have posted the comments and links as a new post "Demography is Destiny" on the main page of my site.

 
At February 01, 2006 9:39 PM, Anonymous doctorwho said...

The oldest Boomer is 60, the youngest 42 (if you buy the '46-'64 definition). There's a long way to go before we boomers are done buying real estate and flushed into the sea.

 

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