The Most Telling Housing Chart You Will Ever See


Looking back at the mortgage crisis that began to unravel publicly in 2007, its significance varies from one person to the next. For some, it is a bitter memory of lost splendor and livelihoods seemingly stripped away. For others, it opened boundless doors of opportunity. No matter which camp you are in (I pray the latter), it would likely be inaccurate to say that there wasn't a certain allure to the events leading up to and, subsequently, following the financial crisis.

The biggest question in my mind has always been when someone could legitimately say that data pointed to a bubble forming in the housing market. While the answer to this is doubtless subjective, the graph below might help to serve as a proxy for the first telltale signs of an impending downturn in the housing market.

Source: S&P Dow Jones Indices; U.S. Census Bureau.

This chart shows an extremely important housing indicator. In essence, this chart shows the ratio of home prices throughout the United States to household income. What is most fascinating is its consistency over the 25 years between 1975 and 2000, where it fluctuated between 2.736 in 1996 and 3.129 in 1988. Then, beginning in 2001, the ratio reached a high point of 3.292 and, instead of reverting to the mean, saw year-after-year record highs until it peaked at 4.827 in 2005. Just to put this in perspective, that means the ratio of home prices to household income rose by almost 65% from the 25-year average, ending in 2000, of 2.928 (lucky real-estate agents!). From there, it declined rather rapidly until it once again hit the 3-to-1 level.

This implies that the mortgage market is out of the woods. But wait -- there's more! Since reaching 3.01 in 2011, the ratio has increased another 11.6% to 3.359, which hints at another bubble forming. However, before you call your brokers and order them to sell all of your holdings, especially those tied to real estate, please keep two things in mind. First, the past is not always indicative of the future, so it is possible that the mortgage market is not heading toward bubble territory (though unlikely, in my opinion; although it's impossible to be sure that another bubble is forming, the chart is clearly deviating from its historic average, due in part to the current low-interest-rate environment). Second, bubbles can take a long time to burst, and according to legendary economist John Maynard Keynes, "The market can remain irrational longer than you can remain solvent."

In summary, I would suggest that you remain patient and continue to monitor this extremely important economic indicator. However, if you do want to play in this field now, there are a few ways to do so.

Ways to play housing
First, an investor could buy way out-of-the-money puts on a company like PulteGroup for fairly cheap. With the company's stock trading around $16, January 2015 puts with a $10 strike price would cost you about $0.80. What this means is that, for $0.80 per share (in blocks of at least 100 shares), an investor could receive the right to sell shares of Pulte for $10 between now and January of 2015. For instance, if shares decline in value to $5 apiece between now and then, the owner of the puts would be able to sell them for $10 each, earning a substantial profit. Of course, this comes with substantial risk in the event that the company sees homebuilding kick into high gear (not to mention that the company's stock is trading near its 52-week low, which implies a rebound may occur).

A second (and to me, more interesting) way to play this market is to invest (whether through buying shares or by purchasing long-term equity-anticipation securities, a.k.a LEAPS) in companies that engage in mortgage-servicing rights, a line of business where a company acts as an intermediary between mortgage owners and bondholders, thereby collecting a fee in the process. Currently, one interesting prospect in that arena is Nationstar Mortgage Holdings . The company has a market capitalization of nearly $5 billion and trades around 16 times earnings. Although the P/E is high and the company's stock recently hit a new 52-week high, it has been benefiting from banks trying to divest themselves of mortgage-servicing rights in lieu of the financial crisis and ensuing regulation that makes the business more costly. Furthermore, as interest rates rise, this is one company that should see increased margins, as it will have the ability to take monthly payments, invest them in low-risk securities, and keep any interest earned in the process when there exists a time lapse between when it collects a payment and when it is required to remit the payment to the bondholders.

The takeaway
No matter what the future holds, I firmly believe that by following the fundamentals behind any investment and keeping up to date with simple, common-sense economic indicators, you will discover that the opportunities in the market are numerous and profitable. Just remember to keep it simple and stay Foolish!

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