"Davidson": Still Doubting Case-Shiller

“Davidson” takes Robert Shiller to task again. A month ago Davidson submitted this post showing Case Shiller methodology flawed.

Robert Shiller’s home pricing analysis has created panic in the hearts of every home owner, every bank lender, home builder, the managements at home furnishing suppliers, lumber companies, cement companies and etc. Lending businesses of every type and description are in shear panic of a highly uncertain and dire future. I believe that Shiller’s widely disseminated forecast needs perspective.

FIRST:

The March 2009 data for NAREIT was released this morning and the index history from 1987-Present is presented below. I use 1987 as a starting point because Congress changed the tax laws to make “tax shelters” uneconomical in 1986 and the tax regime has been the same since. The point I make here is that when we invest in REITs as an allocation, we do so using the common stock and not by buying the actual asset. The NAREIT Index has fallen 67% from Jan 2007 to Feb 2009. The current valuation is well below the historical pace and as long as the tax law does not change, I fully expect the pricing of REITs to return to the historical performance level.

An important factor (but not the only factor) in my thinking is William Isaccs’ Testimony to the House Financial Services Comm on March 12, 2009 which I have attached to this email and I encourage you to read carefully. In his testimony he indicates that Mark-to-Market is today’s worst problem and

“I was Chairman of the FDIC during the banking crisis of the 1980s. The problems in the U.S. financial system in the 1980s, despite what we are hearing from some government leaders and the media, were more serious than we are facing thus far today.”

I urge you to look at the 1990 decline in the NAREIT Index (Chart 1) which Isaccs calls worse than what we see today. The NAREIT Index tells me that the current market has overstated the current situation. (Click on the chart to expand the corners to more easily view the details) Remember when we buy REITs we are buying stocks that represent the market’s perception of the value of the underlying assets. Real estate has never in the history of the NAREIT Index fallen 67%

Chart 1(click to enlarge):

SECOND:

I have reproduced below Shiller’s Unadjusted for Inflation Housing Price Data 1890-2008(Chart 2) taken from Shiller’s http://www.irrationalexuberance.com/ and the comparison of the Shiller late1980’s-early 1990’s (Chart 3) real estate decline vs. the current real estate decline as published at http://paper-money.blogspot.com/

Chart 2: Shiller’s Unadjusted Housing Price Data 1890-2008(click to enlarge)

Chart 3: (click to enlarge)

My first observation is that Robert Shiller makes a broad forecast using the complete period from 1890-2008. When I view his data it is apparent that crucial events in 1933 enabled the Federal Reserve to not only provide economic stabilization during times of distress but to set national baking regulation. My interpretation is that by lessening the downturns in our economy caused by a pre-1933 unregulated financial industry, the Federal Reserve lessened the capital destruction and the US economy and housing stock grew out of post-1933 economic declines from serially higher lows. The effect in home valuations and the gradual willingness to use borrowed funds has provided fulfillment to many American dreams. I have drawn valuation channels for these two very different economic periods and added rates of return that came from this analysis in the chart below. Robert Shiller treats the 1890-2008 price series as having a continuous economic environment.

I had puzzled over Shiller’s forecasts for some time as they appeared so dire, yet the history in the NAREIT above and the Nominal Housing Prices below did not fit the oft repeated forecasts.

The Shiller House Pricing Data is Inflation Adjusted, BUT we think in terms of the Nominal Price and banks lend against the Nominal Price.

Shiller’s forecast is an inflation adjusted forecast, but the media does not present it this way. We think in Nominal Prices, the price we see every day. When Shiller compares price declines during the last home price decline period to those of the current period as is presented in Chart 3 from paper-money.blogspot, these are inflation adjusted prices and not those that we actually experienced in the decline of the late 1980’s-early 1990’s. We experienced a 3% Nominal Price decline from 1990 to 1991.(See the Shiller Unadj Housing Price Data 1987-1997 Chart 4 below) Importantly, banks lend against the Nominal Price not the Inflation Adjusted Price.

Chart 4 (click to enlarge):

Our national panic over falling prices and owners being underwater vs. Inflation Adjusted Cost Basis is not how we or the banks think. It seems that we have suddenly come to accept a pricing methodology that we have never before considered valid.

In my view the current panic heavily promoted by the media needs to step back a bit and not take Robert Shiller’s price decline forecast as a Nominal Price decline forecast which is what I think we are doing.

Disclosure (“none” means no position):