The only certainty, as Keynes put it, is that in the long run we are all dead. This week, John takes a look at the much debated rise in house prices in the context of previous speculative booms and busts.
Is this the end of the house price boom? There has never been a house price bubble, as there was a bubble in dotcom stocks, Victorian railways, or the South Sea company. In all these sagas, it was certain that long-term holders would lose money: the only way to make a profit was to sell on before reality set in.
Some people did think that tulip bulbs had great intrinsic value but the process by which they held these beliefs was similar to the mass hysteria that led people to believe in witches then, or abduction by aliens today. People who believe housing is a good long-term investment may be mistaken but are not irrational or deluded. So are they, in fact, mistaken?
The main, almost the only, argument that commentators use is that the ratio of house prices to incomes is at a historic high. But the wide variation in that multiple within countries and between states is sufficient evidence that this number is not a natural constant. The best way to look at the issue, John Calverley’s new book* provides a useful guide, is to compare house price valuation with the valuation of other assets.
Between 1980 and 2000, share prices in Britain and the US rose by a factor of 10. Since then, British stock values have fallen and house prices have boomed. Only in 2004 did the rise in house prices over the previous 20 years finally catch up with the rise in share prices over the same period.
In the US, this has not happened yet. In the long run, house prices should rise slightly faster than national income, because construction is labour intensive and desirable land is in fixed supply. And, in the long run, share prices should rise slightly less fast than national income, because established companies must, in a dynamic economy, make way for the growth of new ones. And housing investment is less risky than equity investment, because house prices are less volatile and because housing is, especially for owner-occupiers, a hedge against the cost of future consumption.
For these reasons, average rental yields on residential property should, on average, be lower than dividend yields on company shares. But they are not. And even where, as in Britain and the US, rental is still a small part of the total market, rentals are a better guide to affordability and the value of housing services than these price-to-income ratios.
Owner-occupiers are investors, too. So, if house prices are too high today, then it is because other asset prices are also too high. And perhaps they are. Over the past five years, the speculative froth in high technology shares spilled over into all other asset categories. If there is a housing crash ahead, its most likely cause is a crash in financial markets generally.
For many years, finance theorists believed speculative market prices followed a random walk: tomorrow’s movement was as likely to be down as up. Benoit Mandelbrot’s recent book** summarises the strong evidence that has now accumulated that price series display positive serial correlation in the short run and negative serial correlation in the long run. Translated, this means that if prices rose last month they will probably rise in the following month also: but that a period of several years in which prices rise by more than average is generally followed by a period of similar length in which prices rise by less than the average. But just how long is the long run? This is one of the great imponderables of economics – the only certainty, as Keynes explained, is that in the long run we are all dead. The precise interval at which serial outperformance gives way to serial underperformance is itself unpredictable. The consequence is that bulls are usually proved right immediately, and bears are usually proved right eventually. That is why both groups stay in business, and why neither has any profitable information to impart.
Three predictions can be made with confidence: that housing is a good long-term investment, that the current boom will be followed by a slump, and that people who make confident predictions about the future of house prices are mistaken.
* John Calverley, Bubbles and how to survive them, Nicholas Brealey Publishing, London, 2004; ** Benoit Mandelbrot & R.L. Hudson, The (Mis)Behaviour of Markets: a Fractal View of Risk, Ruin and Reward (Profile Books/Basic Books)