Ah, memory lane. It’s been fun watching the DJIA lately. Each time there is a major drop it’s been fun reading how it hasn’t been this low in how many years, upon which I fondly recollect what I was doing back then. Of course, this is fun only because my wealth is stored in U.S. dollars. If my wealth were in stocks, or most other investments except Treasuries, gold, or yen, I imagine this sort of news must be pretty miserable.
Today the DJIA, as you know, opened and closed in the 6000s, for the first time since May 1, 1997. Now, on October 1, 2008, I wrote: “When all is said an[sic] done, the DJIA will be trading close to the 6000 range, and real estate will fall on the order of 50% from peak.” Back then, the DJIA had been hovering around 11,000, and real estate had shown major corrections only in the more sensitive bubble areas; the most bearish professional economists were calling a bottom in the 8000’s. So, I’d like to announce at this point that I was wrong, and why.
What I meant to say was that the DJIA would bottom in the 6000s and house prices would fall by 50% only if there were no recession. Since we are in a severe economic downturn, prices are going to fall father than that.
My predictions were based on a return to fundamentals, in an otherwise healthy economy.
Prices on investments, including real estate, are based on either fundamental value or speculative value. Don’t even think of telling me about “mark to model” or “the value of home ownership;” those are for when you go whining to Congress for a bailout. Fundamental values reflect the price-to-earnings ratio of an investment class. If we take an investment that involves any sort of risk at all, like stocks, bonds, or real estate, the price-to-earnings ratio should generate interest that at least out-performs treasury bonds. The more risky the investment, the greater should be the yield.
For housing, fundamental values are definitively described on Patrick.net, with the conclusion being that monthly payments to own the house (principle, interest, taxes, and insurance) should be less than what it would cost to rent the same house.
If monthly payments are greater than equivalent rent, or if dividends are similar to or less than Treasury bond yields, then the investment is speculative, and disconnected from fundamentals. Buying into a speculative investment might be sensible if one is certain that prices will rise and will sell at the peak. But one should do so with the understanding that prices will, one day, return to fundamentals. Once prices stall, and the capital gains party stops, there is nothing to further support speculative prices, and they return from orbit. The problem with this latest bubble is that even the experts did not realize this simple fact, or did not acknowledge it—to say nothing of ordinary folk taking out mortgages or putting money in 401Ks.
So, if we weren’t in a recession, a DJIA around 6000 would have yielded investment-grade dividends, and house prices falling 50% from bubble peak would make buying cheaper than renting, over the long haul.
But with the economic contraction, profits are falling across the board, and there will be pressure for rents to fall as unemployment builds upon itself, and as falling prices and falling rents continue, as well a tight credit market in response to years of excess, then fundamentals will follow the downward course, and where prices of stocks and houses settle become anyone’s guess.