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UK Housing Market Will Not Bottom Before 2012

Housing-Market / UK Housing Jan 06, 2009 - 11:27 AM GMT

By: Andrew_Butter


Diamond Rated - Best Financial Markets Analysis ArticleUnless "Farrell's" Cycle is broken - Yesterdays News was predicting when the housing bubble would go pop; the game today is predicting the bottom.

In August it was hard to understand how the bursting bubble would affect (or infect), the economy, because thanks to the clever bean counters, information on the number and size of the naked bets was well hidden from outsiders, just as it was from as shareholders, government, and even, by the cloak of denial, from the gamblers themselves.

Now the reality of the collective suicide-attempt has started to be revealed. It doesn't look pretty, even if there are no more "surprises", but who knows? That's why you call them surprises.

>>[IF] the UK economy does not start to grow by mid 2010 and if inflation stays low, which is increasingly how things are looking, >>[THEN] housing won't bottom until at least early 2012 and peak to trough will be about 33% (on the Nationwide Index).

That's using a model that returns house prices (Nationwide and S&P Case-Shiller) with a standard deviation of 4% for over 100 years of data that works for both USA and UK (R-Squared = 99.3%). The only uncertainty in the model is how the economy will perform and where interest rates will go.

How Come?

The Labor government is sticking to its prepared script that 2009 will see the end to the pain. But don't forget it wasn't only USA that shot itself in the foot, in UK Gordon Brown took aim and pulled the trigger all on his own.

Bob Farrell's "Ten Market Rules" says that "markets always return to long-run averages"; that's why, according to this theory (which is in a way a re-hash of the "efficient-market hypothesis"), "excesses in one direction are invariably followed by excesses in the other direction" (1).

Two pieces of information are needed to understand whether these "rules" apply to the current housing cycle in UK; and if so then how? These are (a) what is the long-run average for house prices and (b) how big was the recent excess? explained how (and why) in the long run, average house prices in (both) USA and UK, are a function of nominal GDP per house multiplied by a function of long-term interest rates.

This is a "valuation model" not a "prediction of price model", the logic is superficially similar to the idea that the ratio of personal income (per head or per house) to prices should be constant (in the long-run).

This was the logic used by the few analysts who correctly called the popping of the bubble (for example Yes sure Nouriel Roubani called the big picture (plus or minus three years), although he didn't explain the mechanics, which was that the abscess of house prices burst and that infected everything else.

But the ratio of incomes to prices alone doesn't explain everything.

The difference between the "income model and the "valuation model" is that (a) the valuation model is dimensionally correct and (b) it also explains how long-term interest rates affect house prices in the long-run (which is something neither Allan Greenspan nor his "good friend" Gordon Brown, ever understood).

The basis of the model is an income capitalization valuation done strictly in line with well established valuation standards. This delivers an estimate of where the "long-run" or the "equilibrium" should be, >>[IF] the market was not in what International Valuation Standards calls "disequilibrium", i.e. if "excesses" (a polite word for lunacy) were not pulling prices away from the equilibrium.

In the long run (100 plus years of data) income per head or per house explains 95% of changes in house prices with a Standard Deviation of 13%. The valuation model explains 98.8% with a Standard Deviation of 7%, which is quite a lot more useful, (apart from being consistent with well known rules of the "oldest profession" (before the other oldest profession could get going there had to be a valuation)).

So the valuation model sets the base line.

To predict price it's helpful to know what causes price to depart from the long run "equilibrium value". Why prices go up above the line is yesterdays news, why they go down below the equilibrium line and how long they go down appears to be a function of how far they were above the equilibrium before, why that happens is not altogether clear.

Possibly because it takes time for over-priced assets to be shaken out? People tend to hold on to assets longer than they should when the price is less than they paid, and only sell when they are forced to.

But in any case that's what Farrell's Rule says. Putting it another way if the equilibrium value was calculated correctly any deviation above the equilibrium has by definition to be followed by a deviation below, otherwise the equilibrium was not calculated properly in the first place. International Valuation Standards says it was.

Evidence that Farrell's "10 Market Rules" apply to the housing market:

The evidence in USA and UK is pretty limited. Since the Second World War there were only two major events, the Savings & Loan, and the Lawson Boom, (there are a few other less well known events).

But in both these cases the size of the excess when prices went up above the long-run average (i.e. the equilibrium value in the valuation model), was followed by a slump below the long-run valuation, of a more or less equal amount. Also the timescale of the excess was followed by a slump of a similar timescale.

So it looks like the main difference between housing markets and stock markets (the subject of Farrell's analysis), is only that a 200-day moving average for stocks corresponds to ten to twenty years in housing markets, the mechanism of how excesses translate into slumps appears to be pretty similar; as Farrell's Rules also say, people buy more at the top than the bottom.

What does that mean for housing in UK?

Solving the "valuation model" suggests that house prices in UK (as measured by the Nationwide Index) were 42% above the long run average in October 2007 and in November 2008 they were about 14% above this average.

This suggests that "equilibrium" in UK will be reached mid to end 2009 so the total period of "excess" which started in about 2002 was about seven years.

So if Farrell's Rules apply; prices will not come back to the long-term equilibrium until 2016 to 2017, and prices will bottom at about 40% below the equilibrium line (but remember the equilibrium is going up so that's not an 80% peak to trough).

The timing and the extent of the bottom in prices will be dictated by the rate of nominal economic growth from now until then, plus the level of long-term interest rates.

Current thinking (for example The Economist Poll of Forecasters), is that in 2008 nominal GDP growth was 4.5% and that this will fall to perhaps 3.5% in 2009 (negative real growth but positive inflation). No one is predicting what will happen in 2010 or in 2011 but from where we are standing now it looks like 3.5% might be about the mark.

Long-term interest rates are heading downwards perhaps towards an average of 3.5% over the next three years.

Run those numbers on the "price model" and you get (for the Nationwide Index):

  • 10% drop in house prices from November 2008 to November 2009
  • 8% drop from November 2009 to November 2010
  • 5% drop from November 2010 to November 2011
  • 1% drop from November 2011 to November 2012

    Total peak (Aug 2007) to trough (mid/end 2012) = 33%

    I suppose that's "good news"; said 50%, the head of Barclays recently said we might have another 30% to go (45% peak to trough). But they didn't explain why; the valuation model plus Farrell's Rule does.

    Surely things can't really be THAT bad?

    The government still believes that their new Made in Britain "save the world" policies will turn house prices around by the end of 2009, just like they believed that there were WMD in Iraq (or so they said).

    There is nothing in history to remotely suggest that this makes any sense. The brutal truth is that a lot of people borrowed money to buy houses that are worth less than what they borrowed, for many more their house was the core of their savings plan, which is now busted. That was achieved by smoke and mirrors, piling on more smoke and more mirrors won't change the reality now any more than it did in the past.

    The only thing that will turn things around now is robust GDP growth, real or via inflation, it doesn't matter.

    But for the past seven years a sizeable proportion of the GDP in UK was devoted to persuading people to pay too much for their homes and funding that lunacy, plus all the ancillary "services" that go with encouraging people to commit financial suicide. Whether that actually added any "real" economic value is hard to understand, but in any case that's gone now, and since UK trashed it's manufacturing (big mistake), it's hard to see where the growth is going to come from?

    Surely low long-term interest rates will save the day? Hardly; if the 10-Year note goes down to 2.5% in 2009 and stays there for three years, this would change the peak to trough from 33% to 27%. But that would decimate the pound. The other problem with pushing down long-term rates is that the valuation (present value) of the government's liabilities under their clever PFI schemes will go up. That's something everyone is steadfastly avoiding talking about.

    How about the base rate? Sorry, lowering the base rate only inflates house prices when the direction is up; when the direction is down it has no effect at all outside of the rather small effect via long-term rates.

    Is this the end of Free-Market Economies? The bubble required seven years of extraordinary and extreme stupidity to build-up until it popped. There is not an easy way out, but suspending free enterprise won't help, and the idea of nationalization is sending ominous signals. The government appears to have lost sight of the fact that efficient free-market-economies need proper regulation, not bail-outs and hand-outs to "ease" the pain of previous blindingly stupid mistakes in regulation.

    The starting point to the path of recovery is to face reality, for a change.

    Breaking the cycle of Farrell's Rule

    By training I'm an engineer, vibration, (oscillations around a mean that are self perpetuating), is something that haunts engineers.

    Put a spoke into a vibrating piece of machinery and you might stop the vibration, you might also lose your hand. A long time ago I used to design pipelines and surges (oscillations of water in pipelines) were something I had a deep respect for.

    Shut a pump down suddenly and well the pump stops running, then (if you forgot to put a vacuum breaker on the pump outlet), unseen you get a column separation (a vacuum), then you wait as the surge goes all the way to the end of the pipeline, reflects, then comes back BANG! For a big pump it's the sort of bang you get when you crash a truck into a wall. I once managed (all on my own) to catastrophically rearrange a two ton pump three feet away from where it was supposed to have been, bolts and all...oops!

    The amplitude of the oscillation of house prices around the equilibrium line was allowed to reach a dangerous size. We have had column separation, now we are all sitting around waiting for the inevitable bang, sorry guys, it's not over yet.

    But although there is no-way you can turn back time; or press an "Undo" button to delete the moment of extreme stupidity, there is something that can be done. With a pipeline you put in a huge pressure relief valve, i.e. you change the rules; perhaps there is a way to avoid metaphorically rearranging this pump on the other side of the pump-station, like all the way to Iceland?

    Regulation and Valuation

    As we all sit around waiting for the bang, everyone is twittering about "regulation". The central bankers are saying that capital adequacy provisions should be increased, well yes, that much is obvious, if governments are hauled out of bed one night to run around in their pajamas radically re-capitalizing banks then it doesn't take a rocket scientist to work that out.

    But why is that? Why did the carefully constructed Maginot Line of national and international banking regulation fail so catastrophically?

    Broadly speaking the bankers followed the rules, and no it wasn't because they were slimy and greedy; bankers have always been slimy and greedy, that's why they wear dark suits and carry handkerchiefs, and why we all love them so.

    So they followed the rules and they won't go to jail. So what was it?

    Well consider this:

    The idea of banking regulation is that the Central Bank will act as the lender of last resort, but only if financial service companies that are implicitly or explicitly protected by this facility, follow rules.

    The main rule is that banks should have sufficient capital adequacy to be able to ride out the bets that they make, the ones that go wrong.

    Casinos are subject to similar rules, as illustrated in the film "Ocean Eleven" when a big day on the tables required that funds were available in the vault to cover potential losses.

    The most sophisticated and well-considered banking regulations are the Basel II Guidelines prepared by the Bank of International Settlements (a sort of Central Banker's Club), which provide the agreed template for best-practice banking regulation.

    But Basel II has an Achilles Heel, as do the banking regulations that were in effect in USA and in UK (and elsewhere). It's got to do with valuations.

    What went wrong was not banking regulations per-se, nor was it the fact that some banks didn't follow the rules. What went wrong was that the valuations of assets that were used to assess capital adequacy, were wrong.

    That's stating the obvious again, because by definition if the provisions for capital adequacy had been sufficient, there would not have been a (desperate) requirement for more.

    What happened was that when the bets of the banks (and the insurance and pension companies), started to go wrong, they opened up the vaults in the dungeons of their casinos, only to find that "SURPRISE!" the assets in the vault were not worth half as much as they had previously thought they were.

    With the result that in order to be able to pay their depositors and counter-parties what they owed them (when they had promised to pay), they found that their "capital adequacy" was not enough.

    Spin it however you like, there is no getting around the fact that if the banking regulations had performed as advertised, there would be no banking crisis.

    Surprise-Free Valuation Standards

    The whole point of doing a valuation is that when you come to sell an asset, you don't get a big surprise.

    The International Valuation Standards Committee (IVSC) was set up in the late 1990's by US and UK valuation institutes as a reaction to the Asian Crisis. Remember?

    That was when banks lent a lot of money to be put (mainly) into real estate, mainly in Asia, then the price of real estate went down and there was a crisis of capital adequacy. Sounds familiar?

    The purpose of IVSC was to prevent another CRISIS like the Asian one happening again, like a sort of financial surge-protection device. Well it would have, except that no one installed it on the pipeline - that's what engineers call "Murphy's Law".

    The first edition of International Valuation Standards (IVS) was published in 2000. The standards are now recognized, approved, and accepted by practically every valuation institute in the world, and IVSC is a United Nations NGO (and therefore unlike the guardians of US GAAP and IFRS it is immune to political "sticky fingering").

    IVS are the only valuation standard that explicitly acknowledges that markets are sometimes in "disequilibrium", and they are designed to accommodate such eventualities.

    US GAAP and IFRS are not - but why should they be, they are accounting standards and what do bean-counters know about valuation?

    Since 2000 IVSC has been telling everyone who would listen that the standards used for valuing assets "for the purpose of assessing capital adequacy" (US GAAP and IFRS or variations of these), are "fundamentally flawed and bound to be misleading".

    Yes in particular they told the Bank of International Settlements and in writing (2).

    Translate that into English it says, "If you dumb-asses don't value your assets properly you could be in for a BIG SURPRISE...of the trillion dollar variety".


    Why no one listened is the same reason that Cowboy George and Hop-Along-Blair went into Iraq and why we have the blood of 150,000 Iraqi civilians on our conscience. And there is no way to spin out of that one either, that's what happens when you don't have standards, the Geneva Convention (an internationally accepted standard like IVS), clearly says that invading armies have a duty to protect civilians, regardless of what a smarmy smart-ass US Attorney General says.

    So, what's new?...shit happens, even these days.

    The good news...there is still time to put on the Surge Protector

    Sure some banks are lending so some people can buy houses or finance their business operations, and sure LIBOR spreads are going down and the base-rate is dropping to nothing. But the collateral that banks are now asking for is a lot more than what they used to ask for. The reason for this is that no one believes in the valuations.
    That's logical, the valuations were wrong before, nothing changed, so they could be equally wrong now.

    The value of the collateral for a 100% mortgage written at the peak is now 85% of that and this time next year it will be 75% if you're lucky. So insofar as assessing capital adequacy is concerned if International Valuation Standards had been used the LTV would have been booked at about 135%.

    Even the most total dumb-ass bankers wouldn't lend at 135% LTV (at least without getting a kickback), and even if they did even the most dumb-ass regulators wouldn't have allowed this (at least without getting a knighthood). What happened was that the valuation standards said that LTV was 100%, so everyone said that was (sort of) OK, so long as everyone looked in the wrong direction while the bonuses and the knighthoods were being handed out.

    So right now we are using valuation standards that have been proved absolutely and conclusively to be "fundamentally flawed and bound to be misleading" when relied on as a basis for working out a prudent level of capital adequacy. Just as IVSC said they were in 2000, it's not "news".

    But still Boy George, wonders why his brilliant "save the world" campaign achieved about absolutely nothing except to transfer the gambling debts of a bunch of lunatics from the private sector to the public sector. That's simply denial of reality.

    It is possible to dampen out catastrophic vibrations even after they begin- here's how:

    Well for a start, "if it was easy", like the engineers say, "we would let girls do it".

    International Valuation Standards has two important elements that bean counters find it hard to get their heads around:

    [1]: The PURPOSE of the valuation must be clearly stated.

    Even a bean counter ought to be able to figure out that what that means is that if the purpose changes then the valuation can change.

    For example if the purpose is to assess a tax liability, then you have to follow the tax code, if the purpose is to work out dividends then you have to follow what it says in the stock-market you are listing on, if the purpose is to work out what you could get for the asset today then that's mark to market, and if the purpose is to use the valuation as part of a calculation to assess capital adequacy, that can be something else completely.

    [2]: If the market isn't working today then you should not rely on the market (today) to work out the valuation for some purposes (in particular for assessing capital adequacy).

    For the benefit of the bean counters the explanation for that is a bit like saying "if the breaks on you car are not working (today) then don't drive your kids to school in the car (today), (although it's probably OK to move the car to a place where you can fix it - i.e. for a different purpose).

    How would that stop the "vibration" - or the inevitability of Farrell's Rule?

    The ultimate purpose of capital adequacy provisions is so that if a bet goes wrong you don't get burnt so bad that you set the rest of the world on fire.

    Just as bankers apparently need to have it explained to them that lending money at 135% LTV (as assessed using International Valuation Standards), is dumb, and can ultimately damage the fabric of the economy, they also need it explained to them that lending at 50% LTV (as assessed by IVS), is equally dumb, and can be equally bad for the economy.

    Many assets used to assess capital adequacy are currently valued (mark to market) at a lot less than they would be valued using International Valuation Standards. But so what, no one recognizes IVS? And if you don't do the valuations properly you don't know which are the good assets and which are the toxic ones.

    Apart from affecting mortgages for housing, this affects the ultimate driver of the credit market, the wholesale market.

    The big buyers of bonds, people who have steady incomes (premiums and contributions), and predictable liabilities, i.e. insurance companies and pension funds, are not buying bonds because they are worried that the values of what they buy will get marked down by mark to market rules, and they are not selling either unless they are forced to because the value of many of the bonds they hold are worth more held to maturity. So they are sitting on a pile of cash that just keeps growing.

    Until that market re-starts, nothing will work, unless of course we go backwards (in the direction of the Stone Age), and governments take control of who gets the loans to do business.

    International Valuation Standards would provide a solid platform for re-starting the market.

    That would make sure that assets are valued less than market as a bubble develops, automatically cutting off credit at the right time, and that assets (when valued for the purpose of capital adequacy) would be valued more than mark to market as everything goes into a slump, freeing up credit. That's basically how a surge protection system work, it releases pressure at the right time and introduces air or water into the system to dissipate dangerous vacuum's forming.

    Remember, the whole financial system is a man-made construct, the only thing in this system that can work without government or regulation, is markets. Markets were here before governments were.

    The added benefit of having a "Surge Protection System" would be that the blunt instrument of interest rates could be played around with, with the sole purpose of the economy in general, without having to consider the effect on house prices (after the surge protectors were installed, there wouldn't be any effect).

    That would break the Ferrell Cycle for the simple reason that the rules would have changed. Like a surge protector put on the line to stop those oscillations, sure it hardly ever gets used, once every ten years in the housing market, but boy when you need it, you need it.

    If not, well 33% peak to trough here we come.

    I suppose that's not too bad, it might have been 50%. Although given the amount of collateral damage that "only" 15% caused, it looks like it's still going to hurt a lot when we find ourselves catastrophically relocated to Iceland.

    The option of course is to face up to reality. That's always hard, but it would be "nice" for house prices to bottom some time before the end of 2009, but then again for that to happen some people are going to have to stand up and admit they are fools, and promise to do the right thing from now on (like resign). Not much chance of that happening, so it looks like...Iceland here we come!


    (1): Bob Farrell was chief strategist at Merrill from 1983 to 1992 and won Institutional Investor magazine's award for overall stock market direction in 16 out of 17 years.

    (2): The last letter IVSC wrote to the Bank of International Settlements was in July 2003, a copy of this letter can be found on the BIS website.

    By Andrew Butter

    Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

    Copyright © 2008 Andrew Butter

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