The Continuing Saga of Your House as An "Investment"

Sorry for getting this up late.

CoreLogic released its Negative Equity report for Q3 2012 on January 17, 2013. See here. It reports the number and percentage of homeowners that are “underwater” in their mortgages (owe more than their home is worth) by state.

All in all, 1.3 million mortgages moved from negative to positive equity during the quarter, a generally postive development. Across the nation, 22% of all mortgages are still underwater, down from 23.7% in the Q2 report. Nevada is the undisputed "titleholder" with 57% of mortgages under water; Florida occupies the second slot with 42%.  Nevada and Florida are also first and second in terms of high average loan-to-value ratios with Nevada at an astounding 109% and Florida at 86%.

Other highlights:

• Arizona (39%), Georgia (36%), and Michigan (32%) rounded out the top 5 states with highest percentage of negative equity loans.
  
• Nationally, there are 1.8 million more loans that are only 5% underwater. Another year of increases in prices could wipe another 18% of the negative equity mortgages off the list.
  
• The bulk of the negative equity situation is at the market's low end (homes valued < $200,000). Nationally, 28.7% of all mortgaged homes with values under $200,000  are underwater compared with just 14.5% for homes valued above $200,000.
  
• Net homeowners’ equity in all mortgaged properties increased $200 billion during the quarter from $3.6 trillion to $3.8 trillion. California accounted for 25% of this increase or about $52 billion (California accounts for 22% of the value of all mortgaged residential property). The top 5 states (those listed above) with the most negative equity loans accounted for another 25% of the $200 billion increase in national net homeowners’ equity.

In looking at the data, it's apparent that the worse states showed the most significant improvements. This is most likely due to the higher than average number of foreclosures and short sales (which eliminate mortgage debt entirely) in those states. Also, three of these states (Nevada, Arizona, and Florida) experienced large rates of appreciation in the 3^rd quarter, with some pundits are attributing this to large scale buying by investment groups, such as Blackstone and JP Morgan.

Tobin's q Redux

 John Hussman had a nice post on stock market valuations this Sunday. Article here. John is a very good economist. His weekly Market Comments are on my must-read list. 

In it he quoted the same measure we are so fond of of referencing: Tobin's q. John has been pounding the table about this frothy market for some time. He admits that his warnings are often "early". That is the bane of the vast majority of value managers. It is also their "edge" or value creating discipline. That and the ability to hold on til gains are realized even though initial paper "losses" may appear from taking positions.  Here's what John Hussman said ( for easy reference we repeat the chart given in our last post as well, as did he):

Andrew Smithers out of London provides yet another metric based on Tobin’s q (market value versus replacement cost). The chart below is on log scale, so you have to do a bit of math to translate to percentage over/undervaluation, for example, exp(0.42) = 1.52, or 52% overvaluation.

The chart is based on data through the end of 2012. Smithers notes “At that date the S&P 500 was at 1426 and US non-financials were overvalued by 44% according to q and quoted shares, including financials, were overvalued by 52% according to CAPE. With the S&P 500 at 1552 the overvaluation was 57% for non-financials and 65% for quoted shares.”  

Unfortunately, that seems about right. Let’s translate this into an estimate of prospective 10-year total returns, assuming underlying nominal economic growth rate of about 6.3% (which may be optimistic, but is a robust peak-to-peak norm across economic cycles, and is unlikely to be pessimistic), and a dividend yield of about 2.2% on the S&P 500. With that, a 65% overvaluation in quoted shares, reverting to fair valuation a decade from now, would imply a 10-year annual nominal total return on the S&P 500 of 1.063*(1/1.65)^(1/10) + .022 – 1 = 3.3% annually. That’s right in line with the estimates we obtain from a wide range of other historically reliable approaches (historically reliable in italics, because the “Fed Model” is not).

Notice that in 1982, the -0.7 reading on Smithers’ log-scale chart implied that stocks were undervalued by exp(-0.7)-1 = -50%. At that point, with the dividend yield on the S&P 500 about 6.7%, one would have estimated a 10-year prospective total return for the S&P 500 of 1.063*(1/0.5)^(1/10)+.067 – 1 = 20.6% annually. One would have been correct.

In contrast, note that in 2000, the 1.0 reading implied that stocks were overvalued by exp(1.0)-1 = 172%. At that point, with the dividend yield on the S&P 500 at just 1.2%, one would have estimated a 10-year prospective total return for the S&P 500 of 1.063*(1/2.72)^(1/10)+.012 = -2.6% annually. Again, one would have been correct.

Here's the rub though. Stocks had a long way to run in 1998-2000 from these levels. Not a reason one should adopt for staying of course. They even had a bit more room from 2004-2007. But in both instances a collapse followed and one would have been better off in Treasury bills and waiting for better valuations to appear. If not for the possibility of gains then certainly from a risk management perspective. This is not advice though. Please do your own due diligence!