House Prices: The Long View

There was an interesting post at Debit vs. Credit two days ago suggesting that now may not be the time to buy a house. The gist of the argument was that house prices still have a way to go before they return to normal. This was illustrated with a chart of median new home prices as a ratio to median income since 1963. That’s not the most ideal set of data to use, for reasons that I will spare you.

The most useful measure of house prices are the S&P/Case-Shiller Home Price Indices. They only go back to 1987, but one of the co-inventors of the index, Robert Shiller, has chained together other useful house indexes to patch up a composite going back to 1890. (This is the third post that has mentioned Prof. Shiller in the past month. Just coincidence, I swear.)

I downloaded the data from his site, updated and cleaned up a few things, and produced the following chart, showing the inflation-adjusted sale price index for existing homes since 1890.

If you’ve never seen something like this before, you may be experiencing some shock and confusion. This is normal. Just keep breathing deeply. You thought house prices went up over time, didn’t you? Well, they do, but mostly because of inflation. Recent experience excepted, house prices are generally flat over long periods of time once inflation is factored out.

A few other observations worth making:

1) The last index value in this chart (which is for November 2008) is 144.0, still 13% higher than the 1989 peak of 127.4. That does suggest that we have a little more to go, or at least did as of November. On the other hand, it’s already down 40% from the 2005 peak of 202.5, so the worst may be behind us.

2) The recent run-up in house prices actually began in 1996. (From 1996 to 2005 real prices went up 86%.) It may not have gotten weird enough to be noticed in the media until the last years of the boom, but the index began hitting all-time highs as early as 2000. I mention this because it’s currently fashionable to blame the low interest rates of 2003-04 for the housing bubble. They sure didn’t help, but the worst you can say is that they were gasoline thrown on an already blazing fire.

3) As impressive as the 1996-2005 run up is, it is not entirely out of the ordinary. From 1942 to 1947, real house prices went up 60%, which is the best five year run in history. Further, prices pretty much stabilized after that and did not give back very much of the gain. This needs to be pointed out to those who say, in hindsight, that of course house prices had to fall after 2005, because the rapid gains made in years before were just unsustainable.

So is this a good time to buy a house? That depends. Do you need one to live in? There are many factors to consider, including interest rates, tax breaks and other incentives from the government, and local market conditions. (It is worth stating the possibly obvious that the chart above is a national average. Specifics of a particular area may differ both in the short and long run.)

But if you are looking at a house as a possibly shrewd investment, something you can buy cheap now and sell dear later on, you are likely to be disappointed. Even if the crisis were over today, and house prices returned to their pre-bubble habits, the normal state of things is that they don’t go up very much.

Oh Those Wacky Rich People

For those of you who do not spend your waking hours prowling the blogs and newspapers (e.g. those of you with jobs) I thought I would summarize what I have learned lately.

1) The rich people who (used to) work on Wall Street are morons. Completely incompetent. All of them. “These people are idiots.” says Claire McCaskill, and she’s a senator, so she knows about groups of idiots.

2) Until recently, the idiots who worked on Wall Street, who most Americans associated only with making great piles of money without apparently doing anything useful, were nevertheless loved and trusted by all. There was never any envy or animosity. All that has changed now. “America doesn’t trust you anymore.” said Rep. Mike Capuano (D – MA) to a panel of Wall Street CEOs. And members of congress know a thing or two about not being trusted by America.

3) The really rich people who (used to) run Wall Street are particularly clueless. For years, they paid thousands of somewhat less rich people more than a million dollars a year because it amused them. Sorta like how some babies like watching mobiles. Obviously (see #1) there was nothing special about these workers, so they could have paid them a lot less. Now that the government is in charge, these banks will be run to maximize profit, so they will no longer pay anybody more than $500K a year. That’s not a bad salary for an idiot. Believe me, I know. It’s not like these people could just walk out and spin money for another employer or start a hedge fund or something. They’re idiots.

4) In these stressful times, comic relief is important for all of us, and what could be funnier than laughing at idiots? The New York Times has been making the most of this, with articles and opinion pieces that maximize the Wall Street idiot hilarity. Two weeks ago it was a side-splitting piece about how hard it is to live on $500K in NYC. Today we get one on what happens when the “Rituals of the Rich Meet the Realities of the Economy.” It turns out that those idiots indulge in such obscure rites as having their so-called “suits” put through a process called “dry cleaning.” Apparently, they still practice this behavior, but less often, much to the relief of the staff at Manhattan dry cleaners, who now have more time for reading and other hobbies.

5) Meanwhile, rich people outside Manhattan continue to reaffirm our faith in their judgement. A British bank, Barclays (not one cent of TARP money!) has introduced a Visa Black Card. For a modest $495 a year a person carrying this card will not only be able to buy all those things that a Visa card can buy, but will also get “24-Hour Concierge Service.” And the card itself is made of a carbon graphite substance, meaning it’s not mere plastic but really expensive plastic.

What to Expect from the Stock Market

Just about all mainstream personal finance writers advise making stocks the centerpiece of your investment plan. Most will quote a reassuring average market return over a reassuringly long period and make the argument that for sober long-term investors such as yourself, stocks are the place to be. But few writers explain what that long term average return really means and what expectations you should draw from it.

The first thing to understand is that you cannot expect to actually get that average return in any given year. Get Rich Slowly has a guest post by Carl Richards that patiently makes this point with the use of an elaborate animated presentation. His data has an average return of 10% over eighty years and shows that only twice in that time did the actual market return for a year fall between 9% and 11%. I would hope that this is a nearly obvious point to all stock market investors, but I know better.

Moreover, I worry that by saying that the market has good years and bad ones, but that the long run average is high, people are led to believe that as long as they can stick it out through the ups and downs, after twenty years or so they will get the promised average return. This is not necessarily so. Those long run averages are not that much more predictable than individual years.

To illustrate, I will run some numbers of my own. Yale’s Robert Shiller has a website with the S&P 500 index returns annually back to 1871 as well as some other useful stuff such as inflation rates. It turns out that, sure enough, the average return for the US stock market, as measured by the S&P 500, was 10.08% per year over the 138 years from 1871 to 2008 inclusive.

What do we know from this? We know that funds invested in the market on December 31, 1870 and held through December 31, 2008 would have made an average of 10.08% a year. We do not know what the average returns for the next 138 years will be. 10.08% is a pretty solid guess, and in fact is almost certainly the best guess we’ve got, but it’s still just a guess. There is no “true” expected stock market return, even over long periods of time. Setting market return expectations is not science, just thoughtful estimation based on what has happened in the past.

To get a better feel for how volatile even long term averages can be, consider the 80 year period that Richards uses. The 80 year average return for the period ending in 2007 was 11.52%. But move it forward a year to end in 2008 and you get only 10.46%. That is a big difference considering those two periods are 98.75% identical.

And 80 years is a lot longer than the typical person will be invested in the stock market. For most, there is a critical twenty years or so from middle age to retirement when the nest egg does or doesn’t grow. And the returns for twenty year periods are all over the place.

As it happens, the best twenty year period in the stock market since 1871 was recent enough that a lot of us remember it well. From 1979 to 1998 the market averaged 17.32% a year. One dollar invested at the end of 1978 grew to $24.41 by the end of 1998. At the opposite extreme, 1929-1948 averaged only 3.00% a year. The $1 invested at the end of 1928 became only $1.80 by the end of 1948.

There aren’t a lot of people still around who remember the stock market in 1929-1948. But your parents or grandparents might be able to tell you about the period 1962-1981. The market went up an average of 6.57% per year, which doesn’t sound so bad until you find out that inflation averaged 5.50% over the same period, leaving stock investors with an average real return of only 1.07%.

If you are like me, in your mid-forties and heading into the intense period of investing for retirement, the big question is will the period 2009-2028 be more like 1979-1998 or 1962-1981? Nobody knows.

There were 118 twenty year periods ending from 1890 to 2008. The average twenty year period had an average annual return of 9.22%, but a forth of those periods had returns worse than 7% and a fourth beat 11.5%. And you only get to do this once. Consider the difference in circumstances of a person born in 1933, who turned 45 in 1979 and enjoyed fat returns on his way to retirement in 1998 at 65, with somebody born in 1916 whose nest egg went nowhere in the twenty years before his retirement.

What can you do about this? In the most direct sense, nothing. Diversification will help some, but not by as much as you might like. Bad decades for the stock market tend to be bad decades for bonds and real estate too. The truth is that this is one of the many things in life that are beyond your control.

But you can take it into account when doing your financial planning. If the difference between 8% and 10% returns over the next twenty years is the difference between a comfortable retirement and hoping your kids can support you, you need to reconsider your plans. Expecting 10% a year from the stock market over the long run is reasonable, but counting on it is foolish.

Cops and Regulators

It’s a story that is (appropriately) on the back burner in the media, but the slowly unwinding tale of The Greatest Ponzi Scheme Ever continues. In case you have (appropriately) been paying attention to other things, let me offer a quick recap.

Starting as long as twenty years ago, Bernie Madoff, a well known and successful figure on Wall Street, ran a Ponzi scheme. As with all such scams, he pretended to be putting his clients’ money in a make-believe sure-fire investment. Those few who asked to cash out were given money he raised from other investors. By 2008, Madoff’s imaginary investment empire was worth an imaginary $50 billion.

And he never got caught. Like funds of all kinds, last year he was hit by a wave of people wanting to cash out. Unlike other funds, the money he needed for the withdrawals did not exist. So before things got really really ugly, Bernie turned himself in. (Actually that’s not quite right. He confessed to his sons that he had been running a Ponzi scheme and that he planned to turn himself in. They immediately dropped a dime on Ol‘ Dad. Wall Street is a really tough place.)

That’s a pretty good plotline, but it gets better. If you are, like me, an investment professional in Boston, you have probably met a guy named Harry Markopolos. You might also remember that for several years in the middle of this decade Harry tried to make a living as a freelance financial fraud investigator, sort of a bounty hunter for the investment world. Well it turns out that one of his longest running investigations was Madoff’s ponzi scheme. Markopolos figured out it was a scam as soon as he saw the returns Madoff claimed to be getting in 1999. He then spent the following nine years trying to convince the SEC to do something about it.

We do not yet know why the SEC did nothing. Further plot thickeners such as bribery or blackmail are certainly possible, but not likely. The mundane truth is that the SEC is just not that good at what most people think they do for a living. They are regulators and not cops. There is a difference.

To illustrate this, let me change subjects abruptly to an excellent article in the Atlantic last November by Jeffery Goldberg. It is the account of his concerted multi-year effort to get himself placed on the TSA’s notorious No Fly List. He failed, although he did manage to have a nail clipper and a can of shaving cream confiscated. On other occasions he boarded planes with items that ought to have raised some eyebrows, including lengths of rope, dustmasks, full sized Hezbollah flags, and of course, the traditional box-cutter. He also used badly forged boarding passes and at one point ripped up a stack of them in view of a TSA officer. (I thought the article was hysterically funny. Most of my friends swore they’d never fly again. Go figure.)

The TSA didn’t stop Goldberg for the same reason that the SEC didn’t stop Madoff. They are regulators. They employ large numbers of comparatively underpaid and undertalented people to make sure that most folks mostly keep within regulations most of the time. That can be a worthwhile government function (not in the case of the TSA) but it’s completely different from finding the really bad guys and throwing them in jail.

If you point out an obvious wrongdoer to a cop he will arrest him and then, if necessary, work out exactly which crimes have been broken. Point out to a regulator a wrongdoer who is not obviously breaking any regulations, and the outcome will be paralysis. We don’t know for sure yet, but I will bet real money that is what happened at the SEC. They stood around scratching their heads trying to figure out what SEC rules were being broken by Madoff, couldn’t come up with any, added in the fact that there were no complaining victims, and decided to move on to other cases.

If you are confused (or outraged) that the SEC might not see any obvious violations to pursue with Madoff, you are not thinking like a regulator. Regulators work with very detailed and specific rules that they try to jam everybody and everything into. There is no such thing as “the spirit” of a regulation and no general remit for the regulator to fight evil beyond what is very specifically allowed or not. Madoff was not selling securities, as the law defines them. The SEC had a lot of rules about how Madoff could invest his clients’ money in the public markets, but nobody has alleged that he broke any rules there. (Not surprising, given that he apparently didn’t invest his clients’ money at all.) Expecting the SEC to go after Madoff under the general principle that he might have been carrying out the greatest securities related fraud in history is like expecting the airport screener to take a closer look at the unlikely items in the carry-on of the guy in the al-Qaeda tee shirt. (Seriously. Goldberg wore one. Read the article.)

Markopolos had no direct contact with Madoff. (He still mispronounces his name. It’s MADE-off, as in “Bernie made off with a whole lot of money.”) Which raises the question, why didn’t any of the thousands of other people who must have come across the same data in the course of their business come to the same conclusions as Markopolos did and alert the SEC? It’s possible a few did, but it is clear that the vast majority of financial professionals did nothing. Again, because the SEC are regulators, not cops.

Innocent or guilty, dealing with regulators is a painful drag. As a wag once put it “the process is the penalty.” Unless you are absolutely sure something is rotten you just don’t finger your fellow man to a regulator. And even then probably not. You might call the cops if you thought that perhaps your neighbor was beating his wife, but it is almost inconceivable that you would call the IRS because you knew for a fact he was cheating on his taxes.

Obviously, what the Madoff scam needed was cops, not regulators. But there were lots of cops. This was, after all, plain old fraud in fancy packaging. The police in any of the hundreds of jurisdictions where Madoff’s victims lived could have, in principle, investigated him. And of course there was the FBI. But if Markopolos had brought his story to any of these I am sure they would have all sent him back to the SEC. Wall Street fraud is their thing, isn’t it? The final irony is that had Madoff claimed to be investing his clients’ money in something other than regulated securities, Manhattan real estate for example, he almost certainly would have been stopped a long time ago.

Compared to the global economic crisis and our government’s fumbling responses to it, the Madoff story is relatively minor, almost a comic relief. It would be unfortunate, but not all that unexpected, for the two stories to become intertwined in public memory, as popular imagination blames “accounting scandals” like Enron and Worldcom for the tech bubble bursting and blames fraudsters for the great S&L fiasco of the early 1990s. We already hear vague accusations that the root cause of our problems is a failure of regulators to properly regulate. As regards Madoff, the opposite is true. The regulator did everything we could have expected of it. It was our mistake for expecting anything more.

Bonus Outrage Resolution Understood at WSJ

Today’s Wall Street Journal carries a column by Jason Zweig in which he reveals that the action that the President announced on Wednesday to address the Wall Street Bonus Outrage will have no practical impact. Apparently it takes three days for people who work at the Wall Street Journal to understand what is immediately obvious to those that work on Wall Street. To be fair, it takes almost a day for unemployed hacks like me to get around to posting on a topic.