Bubble Tales

Last week, I conceded that the US housing market is probably a bubble.

“Conceded” not because there was ever a point over the last year when I emphatically argued the opposite. Rather, “conceded” because, as Bridgewater’s Greg Jensen told Bloomberg in a recent interview, bubbles (when the word is used in the market context) are “a classic qualitative thing.”

There’s no settled definition of “bubble” when it comes to asset prices. Given that, I’ve variously insisted it’s a mistake to proclaim you’ve definitively identified one. Claiming you see a bubble today is the surest way to doom yourself to a tomorrow spent adding superlatives the higher asset prices go. Last summer, for example, Jeremy Grantham saw a “Real McCoy bubble.” Stan Druckenmiller saw “the worst risk-reward for equity in my career.” Fast forward a few months and Druckenmiller’s asymmetric risk/reward profile was “an absolute raging mania.” And Grantham’s “Real McCoy” was “a fully-fledged humdinger.”

Had you taken the words of Grantham and Druckenmiller as gospel, you’d likely have missed out on at least part of the single greatest YoY US stock rally in a century. Let that sink in. Stan Druckenmiller, purportedly the “greatest” investor and trader of all time, publicly declared that stocks represented “the worst risk-reward” proposition he’d seen in his entire career just as the S&P was beginning its largest YoY rally in 100 years.

Not to put too fine a point on it, but Druckenmiller’s pseudo-prediction (delivered a year ago this month) could plausibly be described as one of the worst market calls in history. His original remark came on May 12, 2020, during a virtual chat with the Economic Club of New York. The figure (below) shows what happened next (it also documents the evolution of the rhetoric).

I’ve said it before, and I’ll say it again: This is one reason (among many) that you shouldn’t idolize investors and traders. Find a painter. Or a writer. Or an archaeologist. Or a humanitarian. Or an actor. Or an inventor (with an “n”). But not an investor. And definitely not a trader. Great investors understand how to leverage capitalism over the long-term for outsized financial gain. They’re basically cult leaders — capitalism being a religion and such. “Great” traders are nobodies. History won’t remember them. They made a lot of money by putting money they already had on the right horse. That’s it.

Now, back to bubbles. And specifically to US housing. I suggested US housing was a bubble for reasons that have nothing (at all) to do with any methodology or proprietary system like the one Bridgewater claims to have. I called it a bubble because common sense tells me that the average person trying to save for a downpayment can’t possibly keep up with the pace at which house prices are rising. “Annual house price growth achieved a new record high in February,” Lynn Fisher, FHFA’s Deputy Director of the Division of Research and Statistics said last week, noting that the 12.2% gain represented “an increase of $35,000 for a median-priced home that sold a year ago.” When you consider that with the trajectory of lumber prices, it seems wholly unrealistic to me that the current conjuncture is sustainable.

That said, on Friday, I wrote that the bubble in housing “isn’t necessarily the product of speculation as much as it is a confluence of factors which together made for a perfect storm.” That’s a key point. Robert Kaplan spooked markets last week when he told a virtual audience that “we’re now observing excesses and imbalances in markets.” He singled out housing. Obviously, the Fed’s role in pushing down mortgage rates was fuel on the fire last year as pandemic dynamics accelerated a flight to the suburbs, stoking demand at a time when the proliferation of work-from-home arrangements was already making home-buying seem like an attractive alternative to cramped, expensive urban living.

But, again, bubbles (to the extent you can identify them) need not be the product of speculation or any kind of “mania.” Sometimes, circumstances conspire to inflate asset prices beyond what you might think is sustainable (paradoxically, “conspire” isn’t meant to carry a conspiratorial connotation there). Unfortunately for those of us who would like to identify the tipping point, figuring out the “sustainable” threshold turns out to be just as difficult as timing burst bubbles, probably because it’s essentially the same exercise.

On Sunday, Morgan Stanley uttered that most dangerous of all phrases in explaining the situation. “We argue that this time is indeed different,” the bank said. “Unlike 15 years ago, the euphoria in today’s home prices comes down to the logic of demand and supply.”

I’d agree. Well, demand and supply with a low-rate kicker.

Morgan didn’t deny that the pace of appreciation is unsustainable. But they expressed a “strong conviction that we are not experiencing a bubble in US housing.”

Why? Well, again, because unless you view Fed largesse as a nefarious conspiracy, what’s going on in housing is above board and easy to explain. You don’t need a PhD or any experience in structured credit to understand the dynamics.

Taking a trip down memory lane, Morgan distinguished between two types of mortgage risk in the lead up to the housing bust: Borrower risk and product risk. Borrower risk is self-explanatory. Product risk “lies in giving a borrower a type of mortgage that has a higher risk of default, even controlling for borrower characteristics,” the bank wrote, noting that during the pre-GFC period, “inherently risky” affordability products which “required home prices to keep rising and lending standards to remain accommodative so that homeowners could refinance before their monthly payment became unaffordable” accounted for “almost 40% of all first lien mortgages.” Today, that figure is 2%.

Ultimately, plain old demand and supply will dictate where the market goes from here, Morgan said, noting that “millennials continue to drive household formation at a rate 30-50% above the long-run rate of new household formation,” which should keep demand “robust for some time,” the bank remarked, before noting that, contrary to what you might be inclined to believe, affordability actually “remains good” as “monthly mortgage payments as a percentage of income [are] near the most affordable levels in the last five years.” You’re reminded that rates eased back near record lows over the last several weeks (figure below).

At the same time, the supply shortage isn’t abating. With the supply of available existing homes near record lows and the supply of new homes similarly “muted” (as Morgan put it), the market simply isn’t in balance, and that should provide a tailwind.

So, is it a bubble or isn’t it? Well, nobody knows, really.

In the same interview mentioned above, Bridgewater’s Jensen posed a series of questions: “What do you mean by bubble?” “How do you measure that it’s a bubble?” “Is it enough to say prices are high relative to history, or what’s the actual measure?”

Maybe we can ask Jeremy Grantham. Or Stan Druckenmiller.