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Some Insight From Jeremy Grantham
By JLP | February 9, 2008
There was an interesting interview with Jeremy Grantham in this week’s Barron’s. He said a couple of interesting things. The first one was about corporate profit margins and housing prices. It’s not good news (Italics are mine. The bold is Barron’s talking):
Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging world and even in Japan. That was because the global economy was stronger than any corporation counted on and, in the U.S., consumption was always higher and our savings rate was always lower than any corporate economist would have suggested, going into negative territory. But there are a few near certainties in this business — not many, but a few — and one of them is that abnormally high profit margins will go back to normal. The timing is unfortunately shrouded in fog. The other near certainty is that house prices will go back to a normal multiple of family income. In the end, we, the people, have to be able to afford the houses and they are affordable at something around 2.8 times family income. When they peak in Boston at 6 times and nationally at 3.9 times, you know you are in for tough times.
Incidentally, it was late in ‘06 when [Fed Chairman Benjamin] Bernanke said he thought the high prices of homes in the U.S. merely reflected a strong U.S. economy. Was he not looking at the data? Did he not measure long-term house prices? Had he not seen how they ebbed and flowed as a multiple of family income, which they do here and in the U.K. and everywhere else? And with it being so obviously a bubble, how could he have said that?
He was taking his cue from Alan Greenspan, who said we should all be taking out adjustable-rate mortgages.
Greenspan and Bernanke have taken a hands-off approach for two consecutive great bubbles, first in TMT — telecommunications, media and technology — and second, in housing. A hands-off approach is a polite way of saying they facilitated this. And what is the point of a 125-basis-point rate reduction, other than to provide reinforcement for the people who borrow short and lend long? From bankers who have committed every crime you could possibly accuse a banker of, to hedge funds who borrow short, leverage, and invest long in the stock market — that’s who really benefits from the interest-rate reduction. The economy, broadly defined, does not.
I have an exhibit that shows the 30 years prior to 1982 when the debt-to-gross domestic product ratio was completely flat at 1.2 times. Total debt is defined as government debt, personal debt, corporate debt and financial debt. Then in the 25 years after 1982, the flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when debt is flat, annual GDP growth is its usual battleship, growing at 3.5% and hardly twitching. After the massive increase in debt, GDP, far from accelerating, grew at 3%. So debt in the aggregate does not drive the economy. The economy is driven by education, man-hours worked, capital investment and technology. It is not driven by what I owe you and you owe me.
Regarding the sentences in italics:
My wife and I were talking about this the other day. We were wondering how families are able to afford some of the houses that are on the market these days. We have a decent family income and we would NEVER be comfortable paying $300,000 to $450,000 for a house and yet that seems to be within the normal price range of some of the houses they are building in our town. These same people also aren’t driving around town in old beat-up cars. Instead they’re driving Lincoln Navigators and Hummers. I don’t know how they do it.
Anyway, this was in interesing interview with Grantham. Incidentally, he has a target of 1100 for the S&P 500 Index in 2010 (it closed Friday at 1331). It could be rough the next couple of years. However, when has it ever been NOT rough?
Topics: Investing | 13 Comments »
February 10th, 2008 at 12:05 am
I have to agree, how can people afford this? I don’t see how people throw $2k – $3k+ per month on a mortgage. We figured we’re comfortable paying about $1200 to $1300 a month giving us plenty of breathing room. After running the calculators this came out to be a $140k house. So, we started looking around in this price range. Nothing out there worth looking at. At least, if you want a 3 bedroom, 2 bath, 2 car garage with a bonus room and sunroom. To get all these we’re closer to $250k or more.
We need a housing market correction in a big way.
February 10th, 2008 at 1:58 am
[...] Profit margins, the great prop to the market, surprisingly defied the laws of gravity for three years in the developed world and, particularly, in the emerging w orld and even in Japan. … When they peak in Boston at 6 times and nationally at 3. 9 times, you know you are in for tough times…. source: Some Insight From Jeremy Grantham, AllFinancialMatters [...]
February 10th, 2008 at 5:50 am
I think the relevant point of people owning big houses and fancy cars (maybe a boat?) is that often they can’t afford it. It’s all financed with debt. 0 Down! No interest for six months!
Consequently, we end up in situations such as at present.
February 10th, 2008 at 8:44 am
Glad to read your article,
Good luck ,
Tracy Ho
wisdomgettingloaded
February 10th, 2008 at 8:49 am
I just finished my taxes this week, after I was sure I had all of my paperwork in order. Once again I took the standard deduction after adding up all of my mortgage interest to compare.
Every time a discussion comes up about good debt and bad debt, someone chimes in about mortgage debt being good because that interest is deductible. Maybe it is deductible for rich folks, but it’s never going to be deductible for me.
Mortgage debt may be good debt because its costs are offset by the rent you would have paid, because the interest terms are lower than other kinds of debt, and because of the intangible benefits of being in your own home. But the mortgage interest deduction isn’t even on the radar for lots of “regular folks.”
February 10th, 2008 at 10:18 am
Housing prices will turn. As Grantham points out in many of his writings, assets mean revert. Stock prices from the tech bubble took three years to return to sanity. Housing just finished year one.
Also, every major housing depreciation in our nation’s history has taken place during a recession (whether national or local). Texas in the 80s when oil collapsed. LA and NY in the early 90s during the national recession.
We are seeing housing slow ahead of a true recession. If we see a traditional recession with job losses and reduced spending, housing will follow. Currently, sellers do not need to sell. They can anchor to 2005 prices. When more and more folks need to sell, prices will drop.
February 10th, 2008 at 11:13 am
Jeremy Grantham provides home buyers and investors with a
valuable tip for spotting housing bubbles: watch the ratio
of family income to housing prices.
The ratio skyrocketed during the housing bubble for two
reasons: First, the Federal Reserve fueled the housing
boom with historic low interest rates. Second, the Fed
turned a blind eye to risky mortgage products like option
ARMs and negative amortization loans.
February 10th, 2008 at 6:03 pm
Don, are you sure you added all of your deductions – not just mortgage, but property tax, state tax, charitable contributions? You mortgage must be very low and you are probably in a very low tax state. For a $1000 a month in interest – not too high given today’s prices, this would be $12000 a year – already over standard deduction. Add to it property taxes and state income tax (local sales tax if you are in a low tax state) and you are way above standard deduction.
Agree that the home prices will likely to fall more. The ownership cost adjusted for taxes is normally close to the rent one would pay for a similar property. Today there is a huge discrepancy between rents and prices. The slump in the 90s lasted for years (here in NY). As much as I hate the idea of my home value going down, I just don’t see how these prices can hold. How is today’s situation better than what we saw in the 90s?
February 10th, 2008 at 10:37 pm
Don,
You’re right. It’s hard to deduct mortgage interest if that’s the only deduction you have. But, add all the other deductions to it (for us tithe is a big one) and it isn’t as hard to get the deduction.
February 11th, 2008 at 10:23 am
Good post JP, lots of interesting points to ponder. The ‘how do they afford it?’ question comes up quite a bit in my house.
Some insight from my self-employed days: If you’re self employed (non w2 worker) than those Hummers & Suburbans are a huge tax write off. Depending on which way the wind is blowing in Washington (they keep changing the depreciation schedule), you can depreciate any vehicle over 6000 pounds directly lowering your taxable income. Since self-employed people can (as do) write off everything under the sun, there is little income left to tax when they get to the itemized deductions. Kick in a few tax credits and we’re talking zero taxes Plus a check from the IRS.
I’ve talked with tax advisers who’ve dealt with the self-employed all their lives. They’ll advise them to pay taxes for a few years prior to age 65 so they can have SOME income show up and be eligable for Social Security.
It’s easier to afford the huge house and the big cars in the driveway when you don’t pay taxes. If you’re interested, I’ll write an article when my taxes are done this year.
February 11th, 2008 at 4:42 pm
When you think about it, in the long run the price of houses can’t exceed the ability of people to pay the mortgage. In the short run there are bubbles when house prices rise above where they should be, bubbles due to due local and regional market distortions (hot markets), and bubbles due to subprime lending enabling people to buy more house than they can afford. But in the long run, houses can’t appreciate any faster that the ability of people to pay for them does. Someone has to buy the houses.
February 22nd, 2008 at 7:59 pm
Mortgage tax deduction is BAD math anyways.
you have a $10K loan at 10% interest… you pay 1000 bucks for the years interest right? ok.
with the deduction you can remove that 1000 bucks from your income. so if you were in a 25% tax bracket you would pay 250 dollars less in taxes with this deduction.
in essense, you are paying $1.00 to the mortgage company to save 25¢ in taxes. hmmm… i dunno, i’d rather have no mortgage, pay the quarter’s worth of tax and keep the remaining 75¢….
February 22nd, 2008 at 8:07 pm
Chad,
I don’t think the mortgage deduction is bad math at all. It’s a benefit of having a mortgage, but shouldn’t be the only reason to get a mortgage.