— Guest post from Peter Essele, senior investment research analyst
One area of the economy that has been making a strong comeback as of late is the housing market. During the depths of the recession, housing was among the most undervalued areas of the investable spectrum, as affordability reached multidecade highs. Countless valuation metrics, including price-to-rent and price-to-median income ratios, moved well beyond the averages witnessed over previous decades. The mindset of investors toward housing went from viewing it as an asset class that never depreciates to believing that it would never recover—all in a matter of years.
The stability of the market during the dot-com era resulted in significant flows into this asset class, pushing valuations to all-time highs until the house of cards (no pun intended!) began to falter in late 2006 and early 2007. Evidence of this is indicated in the first chart, which shows median home price divided by median income. It’s quite evident from the chart that this ratio reached unsustainable levels in 2005, as median incomes were no longer sufficient to cover median mortgages.
Housing prices, however, have started to come back in a meaningful way, as illustrated in the second chart. The blue line is a ratio of sales to supply. When the metric moves to the upside, we note that sales outpace supply, and when it moves lower, we observe that sales are slowing relative to supply. When we overlay this metric with housing prices and lag it by six months, we clearly see that it’s a fairly decent predictor of price movements. The surge in the blue metric in late 2011 was a good indication that home prices would move higher in 2012, which, we now know, turned out to be the case. The recent stagnation in the blue metric signals that housing prices will likely moderate in the near term. Although sales are still strong, supply has increased recently, causing the metric to slow.
The positive trend in home prices is a significant development for the economy, as it not only relieves pressure on the banking sector and Wall Street, but on Main Street as well. The “wealth effect” that homeowners receive from an increase in home prices has the capacity to translate into real demand for the economy.