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VedantaTrader

An Interesting Correlation...house Prices/ftse

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In the last few months we have had one of the biggest bear market rally's in the history of bear market rally's in stocks. I m sure many will say so what? How has this anything to do with house prices?

Using the analysis software I use I have done an overlay of house prices on the FTSE 100 chart...Many of the housing bulls have likened the stock market to nothing more than gambling, and houses as a much better investment than stocks. Well, I hope to show that in the last 6 years, buying stocks and being a buy to let investor or building houses has been no different. The only difference being that buying the stockmarket index would have been much easier and less time consuming than building houses. With that you also have the fact that the stocks within the stock index would have also payed a dividend which is really the equivalent of rental income. Also having been in stocks would have offered much more diversity than houses with the added liquidity. Therefor one could have sold stocks very easily, within a day, and perhaps escaped with much less financial damage than being stuck with a house falling in value with no potential buyers in line for many months, perhaps even years...

Here is the chart I have done this morning...House Price Overlayed on FTSE 100

I have used the quarterly house prices, I have not added every quarter until the last 18 months, as it was not necessary to show the very tight correlation between the two assets, and also to avoid unnecessary clutter on the chart.

I would say the stock market leads the house price index for the reason that it is much more liquid. The FTSE peaked in July 2007 with a test of this level in November, before the two Bear Stearn hedge funds blew up, and the credit markets began their long freeze, and then the Northern Rock debacle began in August/September.

Stocks Breakdown before Houses

It can be clearly seen that with every new high in the FTSE was accompanied with house prices...and the same can also be said for every new low in the FTSE was also a new low in house prices between November 2007 until March 2009...

The stockmarket made in March what is in my opinion a temporary bottom be it nominal or in real terms. As can be seen in this chart this bottom correlated very nicely with again in my opinion what is a temporory bottom in house prices. The chart shows that as the FTSE has made new quarterly highs so has the housing index right up to the Nationwide release last week.

Now this pattern or correlation began in 2003. Between 2000-2003 there was a disconnect. These correlations and intermarket relationships don't last forever, but they can last for many years. If anyone wants to keep a tighter check on this relationship I suggest that you could put in excel montly house prices in one column and FTSE monthly closes in another and use the correlation function in excel to look for signs that this pattern may be weakening. Right now the correlation is there and is very strong. Perhaps if the correlation declines to below 70% then the pattern may have been broken, anyhow, this is a way to keep check if you are interested.

Here is a chart of the FTSE 2000-2003 where house prices and the market were negatively correlated. As the FTSE crashed house prices rose. The fall in the FTSE between 2000-2003 was a sector based crash, that sector being the technology sector. One only has to look at a chart of the NASDAQ to see how bubbles don't return for years. The BOE cutting of interest rates which between 2000-2004 down to at what the time were historic lows was in my opinion what gave rise to the dramatic 4 year housing bubble.

It was at this time in 2003 in my view that the correlation between house prices and the cyclical stock market bull began between 2003-2007 began. I m also of the opinion that it was low interest rates and the housing market boom which was the catalyst for the stock market bull between 2003-2007.

As credit grew in all sectors of the economy the consumer was there in the form of spending (credit) to bolster earnings of companies in the FTSE. As consumption increased so did earnings. This pushed up the stock market earnings to the 2007 valuations, hence why we had companies like Persimmon, Wimpy going up many multiples. As people liquored themselves up on easy credit in the form of home equity extraction, cheap personal loans and credit cards many stocks across the whole economy went up many multiples on earnings induced from credit.

Also as the outsourcing of labour to Asia increased so did global wage arbitrage. This led to an influx of cheap goods from Asia which we binged on using excessive credit growth. The errors of our policy makers were that they focused on prices and therefor the CPI as a measure of inflation and completely ignored credit growth. However, there was dowward pressure on the CPI due to the above mentioned wage arbitrage and outsourcing of labour, not to mention that a stealth commodity bullmarket was also underway, so this did not feed into prices on the CPI until post 2005. So the BOE and government made the grave error of treating inflation as a price phenomenon rather than a monetary one: Inflation is the growth of money and credit,not whether or not your imported dishwasher is going up in price or not. Yet at the recent BOE testimony they have not learned a sinle thing. They are still focusing on the CPI as a measure of inflation. in 2003-2007, instead credit growth continued to grow to epic proportions until we reached the point where for every £ of real GDP growth we had over £3.50 of debt to achieve this. Even as interest rates started to rise they still did not slow down credit growth, if anything it only increased.

However, as debt levels continued to grow, and interest rates edged up we reached saturation point where interest rates anywhere above 5% were far too high for an overleveraged consumer.

To summarise this point, historic low interest rates of 3.75% were low in 2003 as the economy was not as overleveraged as today.

Today interest rates of 3.75% are much too high for the debt leverage that exists. It even seems that interest rates of 0.50% are too HIGH for the debt levels that exist now, hence why we have these pointless QE policies being undertaken.

Here is my point. It was housing which led to the boom across all sectors in 2003-2007 as a result of low interest rates. We had house prices rising and stocks falling 2000-2003 before the correlation began 2003 until the present day.

This raises a few questions and different possible scenarios.

Will housing lead the stock market this time as in 2003?

Will the stock market lead housing this time in a recovery unlike 2003?

Will both asset classes fall together and neither will lead a recovery akin to the Japanese experience?

Or will both lead a recovery and rise in sync akin to 2003?

You can assign your own probabilities to each of the above...

My view if I m forced to take one, is that stocks will lead the recovery before house prices this time, unlike the period 2000-2003 where house prices led. I think it is possible that stocks could bottom out in the next few years maybe sooner or later, and as stocks begin to rise in real terms house prices will be flat for quite afew years. I think it could be a nearly a decade before house prices make real increases in value. I don't think it will be before stocks, and stocks are still someway off a bottom in my view.

Why are stocks still not near a bottom?

My cyclical view on this is that we are at different stages of the cycle in stocks and real estate. The secular longterm bear in stocks began in 2000, the bear in housing began in 2007. We are ten years into a stockmarket secular bear. However, remember these secular bears usually last more than 15 years as a minimum, and it takes 25 years usually for a sector to reach its former peak in real terms not nominal terms from the bust if it ever does.

So what for the forseable future. As of now the correlation between the FTSE and house prices is there and I think it is one to watch for hints on where things are going in the coming months.

SP_and_PE10_large.gif

The above is a longterm secular chart of the S+P 500 going back to 1870. It shows the Price Earnings values at longterm secular tops and bottoms. For an explanation of the PE see here

It tells a story. I will use the S+P as a proxy for the FTSE as the two are about 99% correlated. So in other words what happens to the S+P happens to the FTSE. The quintiles on the chart show where fair value has been. It is interesting that all market bottoms in the last 110 years have coincided with the PE at an average of 6, with the maximum being 9.1 and the minimum 4.8. The last top was a whopping PE of 44 in 2000 making this stock market bubble one of the biggest ever. As the old saying goes, the bigger the boom, the bigger the bust. So as of August today that PE ratio is at over 19...The lows in MArch were when it reached 13.4. So to call this a stock market bottom when the PE is still two times higher than any other stock market bottom is a little premature, especially if one considers the fact that this was the largest boom, so will we have a much smaller bust than previous busts? I don't see it.

So lets lead this analyse of where we see house prices going from the point of view that stocks are over valued still from a very reliable PE standpoint. It is worth noting that we also can use longterm dividend valuation covering the same period which also corroberates with the findings of the PE study.

1) Stocks have not reached a bottom...

2) Stocks and house prices have a strong correlation today. As of today, to say one has reached a bottom is like saying they both have reached a bottom.

3) As can be seen from the PE and the way it is calculated, to get that PE down to around the 6 level again one of two things has to happen. We either need to get falling stock prices or we have to get rising earnings. I will side that we will get falling stock prices rather than rising earnings per share growth. It was the housing market and credit growth which led to higher earnings on stocks 2003-2007, will the housing market lead again to produce higher earnings? I doubt it, so it will probably have to be falling stock prices. I can't see any other new growth area in the economy which will lead us like the housing boom did 2003-2007. Unemployment is also higher now than rising than it was when it peaked 2003, so where will the jobs growth come from. I think the unemployment rate could remain high for years which leads me to believe we cannot reply on an earnings led recovery.

4) If we follow from point 3 then that means that we will get falling house prices if the correlation stays in place which I think it will for a while yet.

The correlation seems to breakdown at turning points...as in 2000-2003

So to sum up my perspective on where house prices are going from this cyclical analysis...

In 2000-2003 stocks fell hard and house prices increased.

It was the rising house prices and consumer spending which lead to higher stock earnings which drove up stock prices 2003-2007...

House prices were the leading factor 2003-2007...

For that to happen again today we are relying on house prices leading the stock market again. Understanding that no bubble in history has never been reflated straight after it has burst suggests this will not be the case.

This time the correlation will breakdown when stock markets bottoms, and it will be stocks that lead the recovery unlike 2003-2007 when it was houses prices rising which led to the stock market recovery.

So if stocks are to fall in price, then unless we expect house prices to disconnect and start a new bullmarket then house prices will follow the stock market...

I know some will say and think mistakenly that this correlation doesn't have to remain. That is true. But they can last for many years and it is very strong right now. It will not change overnight...

As Doccyboy is predicting from next month we could see a return to falling prices, I concur with this point of view, as historically it has been the autumn period where stock markets have met their misfortune.

Again I don't know if this will be 1930's style, ie a complete collapse or a 1970s style stock market bear where prices increased in nominal terms but fell in real terms due to high inflation. If we do get rising house prices, then they will lag prices rises in other sections of the economy and assets.

Another alternative is that we are in a much larger credit cycle of 40-70 years which has ended so applying the logic of previous house prices crashed in the 1970's and 1990's may not hold any water this time. Credit is being destroyed at an alarming rate. Attitudes to debt may have peaked and changed. It remains to be seen, but there is nothing to rule out a Japanese style deleveraging where stocks are still 80% below there 1989 highs and house prices fell 65% from there 1989 highs.

The previous crashes have occurred within a business cycle within a larger credit cycle. It look like we have reached a longterm term peak credit bubble, so this might play out like no one expects, and not for the better I might add.

The only thing I can see holding stable value in real terms is gold. Gold does not have to go higher it could stay at these prices and increase in value as for example stocks fall 30%, gold drops 5%, house prices drop 25%. This is a net increase in wealth as it falls much less than other assets.

I m using stockmarket valuations to confirm that house prices have quite abit further to fall for the reasons I have alluded to above. Two more confirming pieces of information I use in this is dividend valuations in stocks and the DOW/Gold ratio...dow_au_ratio_lt.gif

At every market bottom this ratio has been between 1 to 2...today we can see it is still well above that, infact at 9 times that. So either the gold rises to 9000USD or the DOW drops to 900, or somewhere in between.

To conclude, stocks and real estate are near perfectly correlated at least for the 6 years and it will not change overnight. So from an alternative view point, watching the stock market will give the clues to where house prices are going. Stocks have not bottomed which means house prices have further to fall, Simple as that.

post-13039-1251646240_thumb.png

post-13039-1251649458_thumb.png

Edited by VedantaTrader

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VT - Have you considered the impact off/effect on sterling?

FTSE weekly here with sterling behind.

http://stockcharts.com/h-sc/ui?s=$FTS...id=p24977580664

and FTSE here relative to sterling (XBP), with fascinating swing points.

http://stockcharts.com/h-sc/ui?s=$FTS...id=p27361544657

I don't have the data to plot house prices vs sterling but I imagine it would tell a similar story. You could probably take a look.

What's interesting is that we would appear to be close to another 'peak' i.e. FTSE relative to sterling.

One would expect sterling is reflecting the change in asset prices (equities, houses) and the impact on the banking and associated industries. You've mentioned DOW:GOLD ratio but of course you can see the same in the FTSE:GOLD ratio too.

http://stockcharts.com/h-sc/ui?s=$FTS...id=p27361544657

Clearly, the activity in sterling (whether managed or market driven) mitigates the falls in equities/houses to those measuring them in sterling terms. i.e. Most of Joe Public. (in fact if you're income, debt and house are in sterling it makes little difference unless you intend leaving anyway).

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I think your houseprice figure on the second graph for January 2008 should be £176,000 rather than £186,000, otherwise the graphs don't correlate very much at all.

According to this nationwide prices the price was £186,000 in the fourth quarter 2007, ie, December 2007/ January 2008. Also I said stocks are more liquid and for that reason you will have more "noise" in a stocks price around the mean. However, my friend the trend between the two exists. In the last few months, each day house prices rises were reported we had the FTSE moving higher on that day and the following days to new highs. Stocks are priced daily, house prices are not, so it will not be an exact fit, however the two have been following each other at the major turning points, and as one made a new high or low, the other did follow. House prices peaked November 2007-FTSE peaked November 2007, House prices bottomed (temporarily) March 2009 as did the FTSE, each rise in house prices in the last few months has been accompanied with the FTSE making new highs.

Edited by VedantaTrader

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Here’s the FTSE100 and the FT-HPI house price index over the period 1980 to 2009, monthly averages, FT-HPI scaled x0.04.

Linear Scale

fjoj2a.png

Logarithmic Scale

9r2i3k.png

Edited by spline

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Here’s the FTSE100 and the FT-HPI house price index over the period 1980 to 2009, monthly averages, FT-HPI scaled x0.04.

Linear Scale

fjoj2a.png

Logarithmic Scale

9r2i3k.png

Thanks Spline. I would say that 2003 until today has been pretty correlated. Did you make those?

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Thanks Spline. I would say that 2003 until today has been pretty correlated. Did you make those?

Hi VT. Yes, and there’s also an interesting post 2005 tight correlation between the house builder stock prices (particularly TW and BDEV) and the housing market transaction proxies (BoE approvals) which themselves correlate against the rate of house price inflation, i.e. d(log house price)/dt.

Some more charts here

http://www.houseprices.uk.net/articles/house_builders_index

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