By Carl Steidtmann, chief economist and director, Consumer Business, Deloitte Research
I don't want to be too sophisticated here, but 2007 is going to suck, all 12 months of the calendar year. Our future is not as bright as what we would like it to be.
— D.R. Horton Chief Executive Officer Donald Tomnitz
It’s not often that one gets such candor from a CEO. But the question that the current state of the housing market begs is: Will housing bring down the economy? This is not a new issue. Back in June 2005 I wrote a piece entitled "The Myth of the Housing Bubble." The conclusion then was that the appreciation in housing prices was not a bubble but a reflection of the very strong fundamentals in the housing market that were limiting supply and boosting demand. It also suggested that at some time in the not too distant future, interest rates would rise and demand would cool but the result would not be the catastrophe that the bubble heads were hoping for. That conclusion was met with some derision by the bubble heads that run some of the housing blogs on the internet. One went so far as to suggest darkly in the summer of 2006: "Maybe it's time to start collecting the names of the housing bubble boosters… . I've considered guys like Carl Steidtmann, who went on record at the top of the market with articles like 'The Housing Bubble Myth' in July 2005.
"I've resisted doing this because, as painful as the tech stock bubble collapse was, I worry that the housing bubble will cause much greater economic damage and inspire far more widespread desperation and hatred. This won't be middle class and upper middle class people, made temporarily rich by a stock market bubble, falling back to earth when it popped. Rather than objects of derision, the housing bubble boosters won't simply wind up as clowns splattered with virtual eggs in the Internet town square. These guys may find themselves the targets of deeper passions, and I don't want iTulip to be any part in that... ."
Quite noble of those iTulip folks not to draw attention to us housing bubble boosters. So here we are nearly two years on and interest rates have risen, mortgage lending practices have been tightened up and housing has cooled. Do we find the middle class wiped out? Are they seething with righteous anger with pitch forks and torches in hand? Are they ready to storm the bastions of so-called housing boosters like the closing scene in some modern day Frankenstein movie? Or does the ‘I’ in iTulip actually stand for idiot?
Why the housing market is not a bubble
A financial bubble has a few distinctive characteristics to it. First and foremost a bubble is a monetary phenomenon. Bubbles are created in large part by central bank mistakes. Massive increases in money supply are a requirement for all bubbles. The NASDAQ bubble was fueled by dramatic growth money supply during the late-1990s. The Fed pumped up the monetary base, first in response to the Asian currency crisis and then later out of concern about the effects of the Y2K bug on the economy.
The result was a dramatic growth in monetary reserves in 1999, much of which ended up fueling equity market speculation. When the monetary fuel for the speculative bubble was removed, the bubble broke. Over the course of the past five years we have seen a steady slowing of money reserve growth, bringing into question the possibility of any asset bubble.
A second sign of a bubble is a big spike in prices. In the year before it peaked, NASDAQ rose by more than 130 percent. The Nikkei was up 84 percent in two years prior to its peak. When the Hunt brothers tried to corner the silver market they created a price bubble that sent silver prices from single digits to over $50 an ounce. Now those were price bubbles.
The best year for housing prices was 2005 when existing home prices rose 13 percent while for new home prices the peak came in 2004 when prices were up nearly 14 percent, hardly the stuff of a real financially driven bubble. You can see how ridiculous the claims of a housing bubble are when you compare new home prices to a real bubble.
A third sign of a bubble is that when it breaks, everyone tries to head for the exits at the same time resulting in a collapse in prices. When the Nikkei bubble broke in 1990, prices declined just over 80 percent over the next decade. Seventeen years later the Nikkei is still half its peak value. The bursting of the NASDAQ bubble took that index down from 5132 to a low of 1108 in eighteen months, a decline of just under 80 percent. Five years later, the NASDAQ is still less than half the peak price.
So what has happened to housing prices since the bubble supposedly broke in 2005? The problem the bubble heads have is that housing prices for the most part are still collapsing upward. Since the summer of 2005, existing home prices are up 12 percent while new home prices have risen 3 percent.
Unlike Internet bubble stocks, Japanese stocks or silver, people still need housing and the demand for housing continues to grow. Population growth creates the need for 1 to 1.2 million new units. Tear downs and depreciation add another 300K to 500K units and second home buying can add another 200K to 400K units or more each and every year. Even in a weak demand year that adds up to 1.5 million units and in a strong year more than 2 million.
There are a lot of reasons why home prices have been rising in this decade. Demographics remain favorable, financing is still cheap, land-use restrictions continue to tighten, second home buying continues to rise and urban gentrification is making for better neighborhoods. All of these have to do with the fundamentals of supply and demand.
Why housing won’t sink the economy
While the action in housing prices in no way resembles a bubble, housing nonetheless has been hurting over the past year. Overbuilding and a slowdown in home sales due to higher interest rates and tighter lending standards have created an overhang of unsold inventory. Housing starts have fallen more than 30 percent. Home price appreciation has slowed and by some measures has declined. Both new and existing home sales are down.
Declines in housing construction in the past have been an early warning of a pending recession in the broad economy. Over the past the declines in home construction have taken 1 percent off of top line GDP growth. That loss has slowed real GDP growth from the 3-3.5 percent range down to the 2-2.5 percent range. It means that the economy is more at risk for a recession, but by itself, not enough to cause a recession.
At its peak, home construction made up a little more than 6 percent of GDP. To get a full blown recession, the problems in housing have to spill over into some other sector of the economy. The most likely candidate for that spillover is the consumer. Making up 70 percent of GDP, any loss of consumer spending could take the economy down.
One of the remarkable characteristics about American consumers is that if you give them cash, they go out and spend it. Real consumer spending has not declined on a quarterly basis since the fourth quarter of 1991. Through currency crises, government shut downs, natural disasters, stock market meltdowns, accounting and financial scandals, terrorist attacks and real recessions American consumers continued to spend. As Morgan Stanley's chronically bearish Stephen Roach has pointed out: "The forecasting landscape has long been littered with carcasses of those who have been dumb enough to bet against the American consumer. From time to time, there have been unconfirmed sightings of my skeletal remains in that heap."
Much is made of the wealth effects of falling housing prices and the loss of refinance money. Refinance activity peaked in the fourth quarter of 2005 and has declined by half since then. Real consumer spending has slowed, but continues to grow at a 3.5 percent clip. Refi could go to zero, but even if that did happen, but it is not likely to have much more of an impact on consumer spending than it already has, which is very little.
Declining home prices could make consumers feel poorer and through a wealth effect, dampen spending. However back in 2001-2, when household wealth really did decline following the breaking of the NASDAQ bubble, consumers continued to spend. And so far, despite the worries of the bubbleheads at places like iTulip, household net worth has risen by some $5 trillion since mid-2005.
What will keep consumers spending is cash flow. Right now consumer cash flow is getting a dual boost from the somewhat unusual combination of steady employment growth and rising real wages.
Conclusions and observations
No business cycle lasts forever and the current one will be no different. In the middle of the expansions of the 1960s, 1980s and 1990s, the Federal Reserve tightened credit policy to dampen inflation. Interest rate sensitive sectors of the economy in general and housing in particular slowed. The weakness in economic growth allowed the Fed to ease policy, producing a jump in the stock market and several more years of growth. While a recession at this point in the business cycle can not be ruled out completely, given the strength of consumer spending, continued slow growth in the economy seems the most likely outcome.
About Carl Steidtmann
Carl Steidtmann is Deloitte Research's chief economist and a director of Consumer Business Research. In 2003 Consulting Magazine selected Dr. Steidtmann as one of the 25 most influential consultants for his work in consumer spending forecasting. He earned his Ph.D., master's and bachelor's degrees from the University of Colorado. He is based in New York.
About Deloitte Research
Operating through a network of research professionals, senior consulting and accounting practitioners, academics and technology partners, Deloitte Research delivers innovative, practical insights companies can use to improve their overall business performance. Through its in-depth publications, surveys, reports and commentary, Deloitte Research identifies, analyzes and explains major issues that drive today's business dynamics and shape tomorrow's marketplace.
