Monday, August 09, 2010

Fun with trendlines

In the comments from a few days ago, JAC asks:
One question for you. You mention that Shiller's "own graph" suggest home prices are still overvalued. When I look at the graph and then "add a trend line" to "home prices", then home prices are indeed below the trend line now, which suggests they are undervalued, no?
My response to JAC was:
Are you including the bubble period in your trend? If you've got a 110-year period of relatively flat prices (adjusted for inflation), followed by a huge and temporary bubble, of course the trendline will be upward sloping. The bubble distorts the trendline's slope.

With my graphs I measure the pre-bubble trend only, to avoid any distortion. And surprise, surprise! It gives me a slope that closely matches the change in rental prices.
Here is Professor Robert Shiller's graph of housing prices (adjusted for inflation) since 1890. On it, I have drawn two trendlines. Eyeballing the two trendlines, which looks to you like a better measure of normal housing prices, the black trendline or the red trendline?

The black trendline measures housing prices for the entire 1890-2010 period, with 1950 being the midpoint. Notice it has two periods that add significant slope to the line. To the left of the midpoint, there is a roughly 25-year dip in prices from the end of World War I to the end of World War II. To the far right of the midpoint, there is a 10-year housing bubble.

The red trendline only measures housing prices for the post-World War II part of the 20th century, i.e. 1945-1999. I'm guessing that most people will see what they want to see, but to my eyes the red trendline is a better measure of normal. It goes straight through the the graph of the 1890-1917 period, even though that's not data used to draw the red trendline.

Now look at this graph, below. The dark blue line graphs housing prices since 1983. The magenta line graphs owner-equivalent rents since 1983. The two straight black lines are trendlines for housing prices and rents, respectively. It should be obvious which trendline is measuring which data set.

Theoretically, housing prices and rents should rise at roughly the same rate. After all, rent is the revenue that housing generates. Yet, in the graph, the house price trendline is significantly steeper than the rent trendline, because the housing bubble distorts the house price trend.


Now look at this graph below. In this graph, the rent trendline has been removed (although the graph of owner-equivalent rent remains). As a replacement for the rent trendline, I have added a trendline for pre-bubble (1983-1999) house prices. Notice that although the pre-bubble trendline is slightly flatter than the graph of rents, its slope is still much closer to the rent line than the original house price trendline. To me, this verifies that a trendline of pre-bubble housing prices is a better measure of normal than a trendline of all housing prices.


Ultimately, however, the change in rents is a better measure of the long-term house price trend than any trendline you can draw.

12 comments:

  1. John Murphy's "Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications" (New York Institute of Finance) is the Bible. There is an actual process for determining a trend line, and I am not seeing that applied here.

    This is the main book that CTAs rely on. It usually takes about 3 years to get a CTA (Certified Technical Analyst), with mandatory prior 3 years of industry experience.

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  2. Thanks James!

    One thing in particular I find compelling from the last few posts is the comparison to owner-equivalent rents. Still, I wonder if full-on elimination of the "bubble period" data is the way to go. I mentioned in a previous comment some trends that might indicate reasons for real estate values to be sustained at some higher price level than in the past--psychological shifts in how we think about real estate as an investment and greater credit availability chief among them.

    And of course the trends seem to remain frustratingly regional...oh to have a Vegas-ian collapse in housing prices in the district so I could scoop something up...

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  3. Anonymous said...
    "John Murphy's 'Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications' (New York Institute of Finance) is the Bible.

    I think a good textbook on time series analysis would be preferable over a technical analysis book any day of the week. Not that I'm claiming to have used one.

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  4. James,

    Having done it both ways for years, the technical analysis is more accurate. Especially chart patterns, of which trend lines are comprised of. Predictive algorithms are generally garbage (even with Monte Carlo testing) without chart patterns, when it comes to anything related to financial markets (including RE). The reason being that the investor is the unknown variable. Statistically sound algorithms work great in a vacuum with no human intervention or market manipulation.

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  5. MRIS stats are out. N. VA prices are up 9.76% YOY, up 12.8% YOYOY (Jul 2008 bottom). In Immunington, prices are up 8% YOY, up 10.5% YOYOY and have hit a new ALL TIME HIGH peak price.

    http://www.mris.com/reports/stats/route.cfm

    Meanwhile, bubbleheads everywhere are crying, screaming at the top of their lungs, inconsolable, bargaining with their creator..."PLEASE GOD, NO MORE GAINS!!! MAKE IT STOP!!! MAKE IT STOP!!! WAAAAAAAHHHHH!!!

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  6. "In Immunington, prices are up 8% YOY, up 10.5% YOYOY and have hit a new ALL TIME HIGH peak price."

    Anon, does "Immunington" mean Arlington or does it mean Washington DC proper?

    I ask because if you mean DC proper, I think it once hit a slightly higher high back in July of a few years ago.

    However, if in your post you mean Immunington = Arlington, fair enough.

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  7. "Anon, does "Immunington" mean Arlington or does it mean Washington DC proper?"

    Here I was referring to Immunington = Arlington.

    YOu are correct for DC proper. DC median price is now (July 2010) 430K, which is -0.2% off the all time Jul high of 431K hit back in 2007.

    See, arent you glad you waited long enough to see the massive price declines the posters on this site long predicted? DC wasnt immune afterall!!!

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  8. "See, arent you glad you waited long enough to see the massive price declines the posters on this site long predicted?"

    Well, for what its worth, I was looking in Alexandria (what you would refer to as Immundria), and it is off -1.5% from its peak prices :)

    Yeah, the idea that -40%, or really even -20% would become prevalent across prime immunington was a pipe dream. Sure, a few houses here or there did go for that much off peak, but for those areas as a whole, its simply stunning how they held up.

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  9. "Well, for what its worth, I was looking in Alexandria (what you would refer to as Immundria), and it is off -1.5% from its peak prices :)"

    I have a buddy down that way. He has been waiting since 2006 to buy and is now (finally) under contract. He is paying 680K for a place that last sold at 699K back in 2006. Roughly a 2.5% price drop.

    He was happy that he is paying 19K less than he would have paid 4 years ago. However, when someone noted he paid about 110K in rent just to see that 19K price decline, he looked as if he wants to kill himself.

    Its a shame he wasnt looking out in Loudoun & PWC where there were real declines.

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  10. prices are also dependent upon incredibly cheap mortgages from FHA.

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  11. special for ......

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