The U.S. Federal Reserve has a super secret set of housing indicators used only by the most elite of bankers. Here’s a plain English guide on how to read them.
This article is an edited ([ ]) and revised (…) version of the original written by Stephen Punwasi to ensure a faster & easier read.
The Federal Reserve Bank of Dallas (a.k.a. the Dallas Fed), publishes a housing index that’s little known outside of the banking world – the Exuberance Indicator. The indicator isn’t often used, because the documentation is highly technical. Today I figured I would break it down into plain English, for all of you Millennials looking to understand the market. This way you’ll have a better read than most people in the real estate industry.
First off, let’s talk exuberance. Exuberance sounds like a good thing, but bankers say it with caution. They’re always on the lookout for when markets become “overly exuberant.” That’s code for when buyers decide to pay a premium on a commodity, for little other reason than everyone else is doing it.
The term didn’t catch on until then US Federal Reserve Chairman Alan Greenspan said it in 1996. When making a speech, he rhetorically asked “how do we know when irrational exuberance has unduly elevated asset prices?” This was three years before the dot-com bubble. Ever since then, the banking industry doesn’t say “bubble” all that often. However, they frequently say markets are “exuberant.” When it gets really bad, a market has become “over” or “irrationally” exuberant. Way cuter and less panic inducing, right?
Measuring exuberance in the stock market is pretty straight forward. There’s a lot of ways to do it, but the most simple would be a stock price-to-earnings. For every dollar a company earns, a buyer pays several more. The thought is, the company will start earning that multiple in five or so years. Sometimes that multiple gets really, really high — to the point where it almost becomes impossible to earn that money in a reasonable amount of time. When buyers pay this premium, they’re buying on exuberance, not realistic expectations.
Measuring Exuberance In Housing
In the past, it wasn’t all that important to measure exuberance in real estate, because it never had the same consequences as a stock market crash. Sure, it sucks to lose money – but it never took out an economy. Consequently, not a lot of cutting edge research went into trying to figure this out, until after the U.S. housing bubble. When that blew in 2008, it triggered the Great Recession. Basically, a real estate crash took out the world’s largest economy.
Since then, everyone’s been scrambling to figure out early warning indicators. Efthymios Pavlidis of Lancaster University, and the Dallas Fed teamed up to create a set of Exuberance Indicators to measure “explosive dynamics.”
Fundamental pricing is established with a few traits like real house prices, price-to-income ratios, and price-to-rent ratios (full working paper here). From there, they look for “explosive episodes” that show prices have deviated from the fundamentals. If they deviate too high, and for too long – markets are vulnerable to correction.
How To Read The Exuberance Indicator
…The indicators include two sets of numbers – home prices and critical values. When home prices go above the critical values, you’re in over-exuberant territory. If it stays there for five quarters, the risk for a housing correction becomes very high.
Exuberance For Canadian Real Estate
The Canadian real estate market has been pretty lucky thus far, with only 3 major spikes in exuberance – late 1980s, the 2000s, and today.
… In the first quarter of 2015, the exuberance indicator went beyond the critical threshold, and continues to today. Over this period cities like Vancouver saw prices rise 59%. Toronto rose to a peak of 55%, before falling to 43% today. Even with the slight pullback, the country’s whole real estate market remains detached from fundamentals according to these indicators… This would require a massive surge in income, or a decline in prices to correct.
Back in July the Dallas Fed tweeted “Exuberance indicators show most risk in Canada’s housing market in 1Q17″
…Preserving real estate prices using further unconventional policies is still an option, but much more dangerous at this point. Interest rates are only 1%, so a 3% cut is probably out of the cards. Even if it was an option, consumer debt levels are so high, increasing them would be a further drag on the economy. After all, more money devoted to servicing debt, is less money that can be spent consuming goods and services. Economies need you to consume goods and services to continue to grow. That’s how jobs get created.
None of this means there is a real estate crash in the picture soon. Isolating just this indicator shows us nothing more than that national prices are greatly detached from fundamentals…
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