Prediction is very difficult, especially if it's about the future.
—Niels Bohr, Nobel laureate in Physics
Almost no one is arguing about whether the U.S. housing market is in decline these days. Prices are skidding across the country. Homebuilding stocks like Lennar, DR Horton, and Pulte Homes have gotten crunched.
Yet many people are wringing their hands over which markets will be the worst hit and how steep the price declines will be. Where will the housing market in Chicago or New York or Miami be next year? Bohr's take on predictions is as true as ever.
Contrasting approaches
Into the breach have stepped economists, analysts, and academics. They're trying to predict where housing markets are headed using everything from econometric analysis to gut instinct. Two of these efforts offer a particularly intriguing contrast in approach. On one side is Mark Zandi, chief economist at Moody's Economy.com, who released a mammoth report on housing prices last week. On the other side are traders and speculators at the Chicago Mercantile Exchange (CME). Just a few months ago, they began trading futures and options contracts on housing prices in 10 markets across the U.S.
The contrast couldn't be more extreme. Zandi is one very smart economist, who mined reams of data to come up with his predictions. He sorted through everything, from employment levels in certain regions to historical housing price increases. At the Chicago Mercantile Exchange, the predictions are determined not by one person, but by a crowd of anyone who wants to participate. They may be real estate investors, economists, or simply speculators with a hunch about where prices are headed.
Neither forecasting approach offers much reassurance for homeowners. Zandi says that housing prices will decline in 2007, which would be the "first decline in national house prices since the Great Depression." He adds that the catalyst for the unwinding of the housing boom is higher interest rates and that the unraveling of some of the markets is due to high speculation and short-term investors, or flippers with the objective of purchasing and then quickly selling those homes.
Reasons for pessimism
Zandi's predictions for specific markets are sobering. The worst hit metro areas, he asserts, will be Cape Coral, Fla., with an 18.6% decline in housing prices; Reno, Nev., with a 17.2% drop; and Stockton, Calif., with a 15.7% fall. To conduct his analysis, Zandi looked at the supply and demand of housing, changes in mortgage rates, demographic trends, the job market, and new housing.
The CME covers just 10 housing markets, rather than the 379 examined by Zandi. The exchange launched the trading in housing prices in May and volumes are still modest, which may affect accuracy. Investors are predicting declines in all 10 cities over the next 12 months. In fact, by August, 2007, when the one-year contract expires, futures traders expect the San Diego real estate prices will have declined 8.2%, Las Vegas 7.9%, and Los Angeles 6.9%. The composite index is expected to fall 6.8%. "The markets are clearly concerned that home prices are going to fall," says Robert Shiller, an economics professor at Yale University. Shiller helped develop the contracts with professor Karl Case and Standard & Poor's. (Which, like BusinessWeek, is a unit of McGraw-Hill.)
In the cases where they cover the same ground, Zandi and the CME traders have some uncanny similarities. For instance, Zandi expects San Diego to drop 8.4% through the second quarter of 2008, while the futures market is expecting a drop of 8.2% by August, 2007. In Washington, Zandi expects prices to drop 12% through the second quarter of 2008, and the futures market expects a 7.7% decline by August, 2007.
Anybody's guess
But in Boston, there's a sharp contrast. Zandi thinks that the worst is over. He estimates that prices declined 2.2% in the second and third quarter of 2006, and that should be the end of the meaningful declines. "Boston's jobs market is coming back, and the city didn't see much froth anyway," says Zandi. But the CME futures markets expect Boston to continue to drop, at least 7% by August, 2007. Similarly, Zandi expects New York to drop 3.5% through the fourth quarter of 2008, while the futures traders are betting that New York's real estate will drop a sharper 6% by next year.
Who would you put your money on? Zandi is certainly a smart, resourceful economist. But "predictive markets" like those used at the CME have proven surprisingly accurate in forecasting everything from the weather to political races. They're particularly accurate when money is on the line, as it is in Chicago.
As Rick Redding, CME managing director for products and services says: "These products create a liquid and transparent market that can be used…to help reduce risks associated with holding real estate assets." This is no academic experiment. The results of these predictions will be made all too public in the months and years ahead.