(One of the sharpest investors we know, a local financial advisor who is also a close friend and collaborator of economist David Rosenberg, thinks the housing market is nowhere near a bottom. In the essay below, one of several we have presented by the same author, he amply supports his thesis, pausing along the way to draw an insight from the Kodak Super 8 movies that his grandfather used to run in reverse.  RA)

Over the last few weeks there have been a larger number of articles written about the housing market. The increased volume is probably attributable to recent data showing that home sales have dropped off sharply since the Home Buyer Credits expired. In addition, we are witnessing increasing foreclosures and a general lack of success in mortgage modification efforts. Certainly economic recovery and housing market recovery go hand in hand, so the spin on housing has tended toward the affirmative in most analysis. Most articles place an emphasis on affordability, which is at or near record levels by most measures, as the primary reason for optimism. The primary deterrents to a more robust turnaround (in addition to the unemployment dilemma) are typically identified as more stringent underwriting conditions and a deflationary mindset among qualified buyers, causing them to hold off on making offers.

What seems to be missing in the analysis is the obvious fact that the overwhelming majority of potential homebuyers also have one to sell. While that has typically been the case, there are several factors that make it substantially more critical to market dynamics now than it has been in the past. When we were experiencing a secular bull market in real estate combined with a secular credit expansion, having a home to sell was an enormous positive because the capital gain on the current home was the source of the increased equity needed to move to a more expensive pad. Between first-time, move-up and second- home buyers, we had a virtuous food chain. Things are much different, post-bubble.

Downsizing Is Where It’s At

I am reminded of my Grandfather and his Kodak Super 8. Many of us Baby Boomers were fortunate to have someone in the family who took movies. We would sit around on the living room floor after dinner and watch past events, with a particular interest in seeing ourselves look funny, or cool. But Grandpa Seeley had created something that we always clamored to watch: a backward movie! It was hilarious and surreal. People filling up Coke bottles with their mouths, cars racing down the street in reverse, Doug emerging from the deep end and landing straight up on the diving board. Of course it was all rather impossible, and the housing market is no different. In order for the housing market to function normally — and this is key — at the margin, there must be a preponderance of first-time and move-up buyers that are willing and able to increase indebtedness to fund the move up. But in the post-bubble reality that we currently face, most market participants, at the margin, wish to downsize.

There are several reasons for this. Most important, during the housing mania, purchases tended to be much more aggressive than would be justified by normal and appropriate shelter requirements. This was because the investment component to home ownership had such enormous allure. Now that it is becoming obvious that prices don’t just go up, most people who overindulged or merely intended to cash out at some point are appropriately interested in reducing their investment exposure.  For a large number of market participants, the desire is acute. Similarly, the supply of first-time and move-up buyers was pulled from the future by the bubble, leaving a vacuum of current candidates. After all, at the peak, creative financing made it cheaper for even the fork-lift operator to own than rent. This was exacerbated by the tax credits extended this year and last.

Deflationary Mindset

Returning to concerns by the pundits over the existence of a developing deflationary mindset, it may be fear rather than opportunism that is keeping potential buyers on the sidelines. That may sound like semantics, but, particularly for first-time buyers, a home purchase does entail substantial mobility risk. Unless prices are appreciating, moves relating both to career change and family size can become too expensive. For the move-up (or down) buyer, putting an offer in before they have a contract on their existing home could end up being a nightmare. During the mania, the passion stirred up by finding that perfect house often clouded judgment enough to ignore the risk of being stuck with two houses. That is certainly no longer the case.

Finally, demographics are a major negative. During the bull market, housing became the retirement investment of choice, not only for Baby Boomers preparing for retirement, but also for current retirees living the dream. Ray DeVoe has always said that Mother Nature seeks out and exploits the hidden flaw. She is a hanging judge. It is therefore understandable that the bubble would burst when the Baby Boomers only had a few short years to go before reaching the finish line. Real Estate Analyst John Woloshin points out that historically 20% of the 65+ cohort rents, but that that percentage is likely to increase substantially. In addition, the percentage of the population 18 to 29 years old and attending college has increased dramatically during the last few years, and because of the debt load they are taking on, they are expected to be renters for a longer period of time, post-education. So affordability is not the defining issue. It is a consequence.

Bob Farrell’s Rule #2

Unfortunately, Mr. Market is the issue and at the margin, the film is jammed, the screen looks like bubbling molasses. We never did stop to figure out how Grandpa did that, but I suppose he just wound the film on the reel backwards. Ultimately the market has to clear and — wouldn’t you know it? — that just leads us right back to Bob Farrell’s Market Rules to Remember. Rule #2 is operative, particularly when viewing the Case Shiller Housing Price Chart. “Excesses in one direction will lead to an opposite excess in the other direction.”  Rule #2 is based on a common sense understanding of supply and demand. Normal human perception dictates that the longer and steeper a market appreciates (or depreciates) the more linear the belief in the trend becomes. Of course, that is not the way the universe actually works. During periods of extreme linear belief, supply explodes (or implodes in the case exponentially rapidly falling markets). Compounding the human perception problem is the fact that, once the market exposes the flaw of linear thinking, belief then retreats to the concept of “fair value.”

But Mr. Market won’t be satisfied until supply is cleared. That is why “extremely cheap” has to follow “manically expensive.” “Fair value” is just a rest stop along the way. The rent/buy calculus, even though it is a moving target, is a central equation in trying to determine “fair value” in the housing market. But just as this metric for fair value was completely abandoned in the face of the marvelous process of capital appreciation during the secular bull market, prices will reflect overwhelming concerns about devaluation, maintenance expense and vacancy risk as well as a general deflationary mentality toward rent at the bottom extreme. It ain’t easy being human. That is why it is good to have rules. In addition to correcting prices, correcting excesses in things such as size, configuration and location will have to occur as well.

We have spoken in the past about the 1973 Lincoln Continental syndrome. The housing bubble resulted in a dramatic increase in the average square footage of homes, even as the average number of people in the family got smaller. Standard equipment became more opulent at all levels. A perception developed that second homes were broadly affordable so vacation and retirement spots were dramatically overbuilt. For all these reasons, supply across the spectrum is extremely large and growing. Much of it is obsolete. Think McMansion developments in marginal neighborhoods. It is very difficult to envision the housing market making a positive contribution to economic growth over the next several years.

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