Downside Risks in the US Housing Market

There are currently some downside risks in the US Housing Market, however the nation’s housing bubble is not collapsing right now. (But three cities are dangerously close: San Francisco, Denver and Dallas)

The U.S. Housing Market: A History of Long-Term Reversion to the Mean
Real estate markets tend to revert to the mean over time. In laymen’s terms, this means that when real estate prices move too far in one direction, they will pull back and return to saner, longer-term valuations.

To illustrate this principle, I’d like to present the below chart. It’s a long-term look at U.S. home prices that have been adjusted for inflation. With respect to mean reversions, it shows how U.S. housing market booms have been repeatedly been followed by housing market busts for the past 50 years.


This chart is a 125-year index of real (i.e. inflation-adjusted) U.S. housing prices that go all the way back to 1890. The index was created by Robert J. Shiller, who is a Professor of Economics at Yale University and a 2013 recipient of a Nobel Prize in Economic Sciences for his “empirical analysis of asset prices.”

If we focus only on the 1965 to 2016 time frame, a straight upward sloping trend-line can be drawn that has marked the bottom of each U.S. housing market bust for the last 50 years. It’s not perfect – but it’s not a wild guess either – and it is this observation that enables us to estimate how far U.S. home prices are likely to fall when the current housing boom ends – and the next housing bust starts.

The most current index reading is 181.01 (for May 2016) – and my key real estate indicators still point to higher housing prices ahead. But for the sake of example, if we assume that prices were to start turning down from the May level, the 50-year historical pattern suggests that inflation-adjusted U.S. housing prices would fall 22.7% if they were to revert back to the
trend line.

And how far would California housing prices fall? I might add another 5% to 10% to that 22.7% estimate because as previously shown, California housing prices are significantly more volatile than national prices.

Three Case-Shiller Cities In the Bubble Zone
The YOY momentum readings for Case-Shiller 20-City Index has been rising in a tight 5.1% to 5.8% price range since September 2015.

This lack of increasing price acceleration and relatively modest price growth suggests that speculation in the broad U.S. housing market is not running rampant at this time, which in turn suggests that – at least on a national level – we are probably not in a dangerous and unsustainable asset bubble right now.

However, what may be true on a national basis, may or may not be true on an individual city-by-city basis. To at least some degree, all housing is local.

As illustrated below, I have identified three Case-Shiller cities that I believe are in a bubble, or close to it: San Francisco, Denver, and Dallas.


A bubble is any asset whose price has moved at least two standard deviations above its longer-term statistical mean (or norm). Thus when a two standard deviation price event occurs in any asset – including real estate – the records of history show that it is almost a 100% dead-certainty that a severe price correction lies in wait – whereby prices eventually revert back to their historical mean, or close to it.

The Case-Shiller Index for San Francisco (which covers five different Bay Area counties) has risen a staggering 82.3% in the last four years – which is an average annual rise
of 20.6% per year! This rapid and massive price move almost surely is greater than a two standard deviation event (in fact it’s probably above 3) – which by definition makes the San Francisco housing market a bubble.

Housing prices in San Francisco County (i.e. “The City”) have gone up even faster than the Case-Shiller Index for the Bay Area as a whole. They have risen approximately 100% in the last four years – which represents an average annual rise of 25% per year.

Is this beginning to sound like a bubble? That’s because it is.
Does that mean now would be a good time to sell? No, not necessarily. The reason being is that the trend is still up – and as we know from the 2000-2006 episode, asset bubbles can inflate more than most people ever believed possible.

Nevertheless, because San Francisco home prices have risen too high and too fast –
I therefore believe it is only a matter of time before this overly-inflated housing market takes another fall similar to the one that occurred from 2006 to 2009 – which took San Francisco housing prices lower by 46.1%.

Let’s now look at the Denver and Dallas housing markets – and let me explain why
I think they too may be in the midst of housing bubbles.

Are Denver and Dallas also in housing bubbles?
Compared to San Francisco, I am not nearly as confident that Denver and Dallas are
in housing bubbles, but an analysis of the numbers tell me that they could be – or at least will be in bubbles soon if housing prices in these two cities keep rising at their current rates, which are about double the national average.

During the 2000-2006 bubble years, the Case-Shiller 20-City Index rose 84.6%. However, if you look at the chart on the previous page, you’ll see that Denver and Dallas did not get as caught up in the speculative mania that gripped the rest of the country – the proof being that housing prices only rose 40.3% and 26.3% respectively in those two cities during that six-year bubble period.

National housing prices fell 27.4% during the crash, Denver (-14.3%) and Dallas
(-10.8) fell far less.

Thus if we look at the recent 2000-2012 time period through good housing markets and bad, it suggests that Denver and Dallas tend to experience price movements that are about
50-60% less than the Case-Shiller national average.

However since the start of the housing recovery in 2012, Dallas (+34.5%) and especially Denver (+47.0%) has outperformed the national rate of home price appreciation (+31.5%) – and not underperforming it like they did during the bubble years.

Furthermore, Denver home prices are now slightly higher than the national average, which hasn’t been the case since 2002. Plus, home prices in Denver rose 40.3% during the bubble years but are now up almost 20% more than that since 2012.

This suggests to me that Denver’s strongly performing housing market has probably been fueled by excess speculation and irrational exuberance since 2012 – which is the fuel that creates an asset bubble.

Dallas, although to a lesser degree than Denver, is also showing signs that it too may be in a housing bubble. Like Denver, home prices in Dallas have not only appreciated more than the national averages since 2012 – but they have also appreciated more during the last four years (+34.5%) than they did during the entire six year bubble period (+26.3%) – which is a 31.2% increase.

And lastly, trust what your eyes are telling you. Take another look at the previous chart. Relative to the historical price patterns that occurred from 2000 to 2012, does the recent rise in home prices from 2012 to 2016 for both Denver and Dallas look ordinary to you –
or does it look like they are overdone?

What does this mean to investors?
It suggests that when this housing market upcycle ends, the downturn in home prices in Denver and Dallas will likely be worse than the national average – and home prices in San Francisco will likely be much worse.

Read last weeks post here the Interest Rate Market

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