The well-known book about the 2008 financial crisis, ‘After the Music Stopped’ opens with a quote from the CEO of Citigroup Chuck Prince:
“When the music stops… things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
This gives us a peak into where we are today.
There is still a lot of interest in real estate from an inflation hedge perspective, with record-breaking sales continuing to make news in Palm Beach, the Hamptons, and other top spots for the 1% of the 1%.
But, there have also been a series of red flags that most have ignored, citing the disparity of supply and demand as the reason why housing is insulated from any downward pressure and rationalizing price increases of 20% y/y on average. Ah yes, and a TikTok influencer said that real estate is immune to underlying economic conditions.
Now for a reality check: Inflation is pumping and is persistent. Interest rates will continue to increase at least double the pace the Fed initially indicated. Dependance on international oil has increased gas prices to over $6/gallon in some areas of the continental US. The war in Ukraine has created a food shortage stemming from instability in the world’s bread basket. A labor shortage has prevented builders from accommodating the needed 3 million+ national housing units. Investment firms like Blackstone have strategically bought affordable single-family housing at scale forcing many would-be buyers to become perpetual renters. Years of cheap money has encouraged individuals and businesses to leverage far beyond recommendations. Margin debt is still hovering around $800 billion (after all-time high of $936 billion). More than $1 trillion in crypto wealth vanished in less than 6 months. GDP is down 1.4% while CPI is up 8.3% and salaries are only growing at 3.4%.
People have very short memories. Yes, inputs look very different today compared to 1949, 1973, 1980, 1990, or 2008, but the outcome will be the same. It’s always about leverage. Think same/same but different.
As credit becomes more expensive, businesses lose the ability to finance every day needs - like meeting payroll, buying materials, and investing in equipment. This results in scaling back which then creates layoffs. This is called ‘Demand Destruction.’
When coupled with inflation, it’s a perfect storm. On an individual level, it doesn’t matter if your mortgage is locked at 2.5% if the rest of your life is 15% more expensive. Inflation is by nature persistent, and once you feel it’s effects, you’re already in knee-deep.
In order to adjust for inflation in the housing market, let’s look at ‘real home prices,’ aka home prices deflated by CPI. The last housing bubble occurred when this ratio (Case Schiller price index divided by CPI) hit .91. Today it stands at a historic high of 1.01. This chart shows how real home prices have progressively outstripped inflation, a trend that has accelerated in recent decades. Home prices have eclipsed the inflation rate by 150% since 1970. In fact, if home prices grew at the same rate as inflation since 1970, the median home price today would be just $177,788 – rather than $408,100. That said, the data indicates that we have seen peak real pricing and can expect a pullback as a result of demand destruction (see charts below).
A ‘Minsky Moment’ is the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. The current bull market started in 2009, an unprecedented 13-year run. The first 11 years of this run was a modest and steady recovery, with the last two years bringing a high-velocity pop to equity and home values.
The problem is, ‘markets will stay irrational longer than you can stay solvent,’ so even though we see the writing on the wall, there is a danger in trying to time the market because the fallout can come much more quickly, or much farther in the future, than expected.
With 94% of Americans concerned about inflation and bi-partisan agreement on the likelihood of a recession, it seems like we are all finally on the same page about something.
That said; Recessions are not all bad; they expose frauds and allow responsible investors to take advantage of price reductions. So, if you’re not over-leveraged, this could be the moment you were waiting for.