Now that it’s clear home prices are beginning to decline, the obvious question is, “how far will they fall?”

In order to answer this question it is important to understand where we are and how we got here. Jeremy Grantham, chairman of investment firm GMO, LLC, has studied every asset bubble, defined as a move in price greater than 2 standard deviations above it’s long-term trend, in modern history. The type of price move that qualifies as a bubble under this definition should occur once only every 40 years and Grantham has found only 28 instances of price bubbles across all asset classes in modern history.

When measured against almost any type of yard stick such as incomes, rental rates or inflation, real estate prices have, in fact, attained this rarified status in the past few years. And according to Grantham, all but 1 of the 28 bubbles he’s recorded has returned to it’s normal trend over time. “I am patiently waiting for the 28th bubble, the S&P 500, to go all the way back to trend,” he writes. Indeed, after the bear market that began in 2000, it’s well on it’s way.

All of these indicators that tell us real estate is truly a bubble show that real estate is overvalued approximately 20 to 40% nationwide. This implies that, in order to return to its historical trend, real estate would need to decline in price a minimum of roughly 20% from current levels. Keep in mind that these are national numbers. Areas that boomed greater than average will necessarily experience greater busts and vice versa.

An inflation-adjusted chart of home prices since 1890, created by economist Robert J. Shiller, shows the dramatic rise in prices in recent years and implies how far they have to fall:

Dramatic price declines, equal to the price inflation of the past few years, will be driven by many factors. Speculators that were enticed by the prospect of flipping their way to millions have now flipped from buyers to sellers throwing their considerable weight from the demand side to the supply side of the price equation.

Looming problems in the finance industry will result in rising foreclosures that add inventory to the already saturated market; in addition, these problems will make borrowing to purchase a home far more difficult.

Another major problem facing the real estate market is the fact that the economy has become so dependent upon it. Real estate jobs have been responsible for over one-third of the nation’s job growth over the last four years. Without a booming real estate market the overall job market will taper off dramatically. Declining transaction volumes will actually neccesitate a loss of jobs among realtors, mortgage brokers, builders, etc.

Rising home prices have also created a boom in cash-out refinancing that has been a large contributor to economic growth. Without this stimulus, the economy would have essentially suffered a prolonged recession since 2001:

All of the factors that have supported rising home prices are now reversing themselves. The vicious cycle of rising home prices attracting new money into the asset class is beginning to spin backwards and will ultimately exacerbate the downside of the boom.

This is how a bubble pops. And we all have front row seats at the popping of the biggest bubble in history.
LIV

And maybe a thousand points…

LIV

Now that it’s clear home prices are beginning to decline, the obvious question is, “how far will they fall?”

In order to answer this question it is important to understand where we are and how we got here. Jeremy Grantham, chairman of investment firm GMO, LLC, has studied every asset bubble, defined as a move in price greater than 2 standard deviations above it’s long-term trend, in modern history. The type of price move that qualifies as a bubble under this definition should occur once only every 40 years and Grantham has found only 28 instances of price bubbles across all asset classes in modern history.

When measured against almost any type of yard stick such as incomes, rental rates or inflation, real estate prices have, in fact, attained this rarified status in the past few years. And according to Grantham, all but 1 of the 28 bubbles he’s recorded has returned to it’s normal trend over time. “I am patiently waiting for the 28th bubble, the S&P 500, to go all the way back to trend,” he writes. Indeed, after the bear market that began in 2000, it’s well on it’s way.

All of these indicators that tell us real estate is truly a bubble show that real estate is overvalued approximately 20 to 40% nationwide. This implies that, in order to return to its historical trend, real estate would need to decline in price a minimum of roughly 20% from current levels. Keep in mind that these are national numbers. Areas that boomed greater than average will necessarily experience greater busts and vice versa.

An inflation-adjusted chart of home prices since 1890, created by economist Robert J. Shiller, shows the dramatic rise in prices in recent years and implies how far they have to fall:

Dramatic price declines, equal to the price inflation of the past few years, will be driven by many factors. Speculators that were enticed by the prospect of flipping their way to millions have now flipped from buyers to sellers throwing their considerable weight from the demand side to the supply side of the price equation.

Looming problems in the finance industry will result in rising foreclosures that add inventory to the already saturated market; in addition, these problems will make borrowing to purchase a home far more difficult.

Another major problem facing the real estate market is the fact that the economy has become so dependent upon it. Real estate jobs have been responsible for over one-third of the nation’s job growth over the last four years. Without a booming real estate market the overall job market will taper off dramatically. Declining transaction volumes will actually neccesitate a loss of jobs among realtors, mortgage brokers, builders, etc.

Rising home prices have also created a boom in cash-out refinancing that has been a large contributor to economic growth. Without this stimulus, the economy would have essentially suffered a prolonged recession since 2001:

All of the factors that have supported rising home prices are now reversing themselves. The vicious cycle of rising home prices attracting new money into the asset class is beginning to spin backwards and will ultimately exacerbate the downside of the boom.

This is how a bubble pops. And we all have front row seats at the popping of the biggest bubble in history.
LIV

And maybe a thousand points…

LIV

In these pages over the past months I’ve written much about the fundamental problems facing most asset classes including bonds and real estate in addition to equities. Now, I believe, there is ample technical evidence to corroborate the fundamental case for caution.

Since mid-June the S&P 500 has managed to regain a large portion of what it lost in the late spring decline. However, the price action appears to corrective rather than the start of a new bull run. The clear wedge on the chart shows, according to Edwards and Magee in their classic book “Technical Analysis of Stock Trends,” “a gradual petering out of investment interest. Prices advance, but each new up wave is feebler than the last. Finally, demand fails entirely and the trend reverses. Thus, a Rising Wedge typifies a situation which is growing progressively weaker in the technical sense.”

In addition, many divergences with prices are also suggesting that this rally may be nearing an end. The amount of net new highs on the New York Stock Exchange has not kept pace with the index.

The Advance Decline Line (a measure of the market’s breadth) is also not confirming the recent strength in prices just as it failed to confirm the May highs.

A big reason for these divergences is the fact that small cap stocks, which have lead the market in recent years, have been lagging dramatically behind their larger cap brethren in this latest rally. This is fairly obvious when looking at a chart of the Russell 2000. What is a little less obvious is the bearish pattern in this index, a descending triangle. The pattern, according to Murphy’s popular, “Technical Analysis of the Financial Markets,” is, “generally considered a bearish pattern… This pattern indicates that sellers are more aggressive than buyers, and is usually resolved to the downside.”

So the market leaders are now laggards. What once was strong, now is weak. The fact that investors currently prefer the blue chips is, in and of itself, a sign that risk is being shunned. This is not the mindset that drives bull markets.

Another measure of investor sentiment, The CBOE Volatility Index, is also indicating prices may have little upside left as it recently registered a sell signal.

Thus the short-term climate is not quite amenable to continued gains in stock prices. But what concerns me even more are the larger signs of trouble.

Longer-term, there are a few indicators that suggest the bear may be reemerging from hibernation. The S&P 500 Index has now broken 3 fan lines, which, according to Murphy, is a, “valid trend reversal signal.” In other words, the bull market trend that began in 2003 is over.

Turning to another of the major indexes, the Nasdaq Composite, we can see another important trend reversal signal. See if you can find the last time these two moving averages difinitively crossed. That’s right, Fall 2000, the beginning of an 80%+ decline in this index in two years time. (Click on the chart for a better view. If you look carefully you can also see a bearish “ascending wedge” that formed after the initial decline from the March 2000 peak, similar to the one that can now be seen in the S&P.)

In a seminar I attended last Summer with Tom DeMark, he noted, in a rather Yogi Berra-ish way, that, “tops are made by the last buyer buying.” Right now mutual fund cash levels suggest that there may not be many more buyers to follow those that were active in May. In fact, funds are carrying less cash in their portfolios as a percentage of total assets than they did at the peak in 2000.

All of this strongly suggests that it’s time for investors to err on the side of caution. Combined with the many fundamental issues facing the major asset classes today, the technical landscape suggests the bear may be back.
LIV

In these pages over the past months I’ve written much about the fundamental problems facing most asset classes including bonds and real estate in addition to equities. Now, I believe, there is ample technical evidence to corroborate the fundamental case for caution.

Since mid-June the S&P 500 has managed to regain a large portion of what it lost in the late spring decline. However, the price action appears to corrective rather than the start of a new bull run. The clear wedge on the chart shows, according to Edwards and Magee in their classic book “Technical Analysis of Stock Trends,” “a gradual petering out of investment interest. Prices advance, but each new up wave is feebler than the last. Finally, demand fails entirely and the trend reverses. Thus, a Rising Wedge typifies a situation which is growing progressively weaker in the technical sense.”

In addition, many divergences with prices are also suggesting that this rally may be nearing an end. The amount of net new highs on the New York Stock Exchange has not kept pace with the index.

The Advance Decline Line (a measure of the market’s breadth) is also not confirming the recent strength in prices just as it failed to confirm the May highs.

A big reason for these divergences is the fact that small cap stocks, which have lead the market in recent years, have been lagging dramatically behind their larger cap brethren in this latest rally. This is fairly obvious when looking at a chart of the Russell 2000. What is a little less obvious is the bearish pattern in this index, a descending triangle. The pattern, according to Murphy’s popular, “Technical Analysis of the Financial Markets,” is, “generally considered a bearish pattern… This pattern indicates that sellers are more aggressive than buyers, and is usually resolved to the downside.”

So the market leaders are now laggards. What once was strong, now is weak. The fact that investors currently prefer the blue chips is, in and of itself, a sign that risk is being shunned. This is not the mindset that drives bull markets.

Another measure of investor sentiment, The CBOE Volatility Index, is also indicating prices may have little upside left as it recently registered a sell signal.

Thus the short-term climate is not quite amenable to continued gains in stock prices. But what concerns me even more are the larger signs of trouble.

Longer-term, there are a few indicators that suggest the bear may be reemerging from hibernation. The S&P 500 Index has now broken 3 fan lines, which, according to Murphy, is a, “valid trend reversal signal.” In other words, the bull market trend that began in 2003 is over.

Turning to another of the major indexes, the Nasdaq Composite, we can see another important trend reversal signal. See if you can find the last time these two moving averages difinitively crossed. That’s right, Fall 2000, the beginning of an 80%+ decline in this index in two years time. (Click on the chart for a better view. If you look carefully you can also see a bearish “ascending wedge” that formed after the initial decline from the March 2000 peak, similar to the one that can now be seen in the S&P.)

In a seminar I attended last Summer with Tom DeMark, he noted, in a rather Yogi Berra-ish way, that, “tops are made by the last buyer buying.” Right now mutual fund cash levels suggest that there may not be many more buyers to follow those that were active in May. In fact, funds are carrying less cash in their portfolios as a percentage of total assets than they did at the peak in 2000.

All of this strongly suggests that it’s time for investors to err on the side of caution. Combined with the many fundamental issues facing the major asset classes today, the technical landscape suggests the bear may be back.
LIV