Prices for the CME Case Shiller home price index futures moved modestly higher during 2019. The table below compares the closing prices for the CS 10-city index contract, and the ten regional component contracts, between Dec. 31, 2018 and Jan 5, 2020 (I was travelling at year-end 2019). Price differences are tallied and then converted into percentage gains (in the far right column). The percentage changes have been formatted to show the regional contracts with the largest gains (MIA +3.7%, WDC +3.5%, and SDG +3.4%)- in green, as well as those that had the smallest gains (CHI +1.5%, LAX +2.0%, and SFR +2.0%) - in red.
I would think that at least three factors contributed to these increases (the stock market, interest rates, and convergence)
1) The S&P 500 index gained almost 30% during 2019. I agree with the view that increases in wealth (all else constant) can have a positive impact on home prices -both as those who've experienced gains have more money for a down-payment (or all-cash purchases), and that real estate can be a partial substitute investment for stocks. However, note that the gains in home price futures were only ~10% of the gains in stocks. This speaks to the very different forces driving each market, and more importantly, to the lack of the stock market (which the wealthy tend to own) to act as a proxy for the economic health of the overall economy and middle class (who tend to have a much larger percent of their personal wealth tied up in the value of their primary residence.^1 That is, those that have owned stocks have seen incredible gains, while those that own homes have not. ^2
2) The Freddie Mac mortgage rate fell by over 75 basis points, dropping by ~16%. Such a decline in rates feeds directly into affordability -a key component for those buying homes with a mortgage. As above, I might have expected a much bigger move in home price futures -given only such a decline in rates (i.e. absent a move in stock prices). In hindsight, it might be argued that the rate cuts just helped reverse what started out as a sharp sell-off in home price futures (going back to Labor Day 2018) when home sales in California began to collapse.
3) Finally, as I've argued in prior blogs, it's my belief that home price futures (i.e. with 1-4 years to expiration) probably clear at a discount to expectations. That's because, in the flow of inquiries I receive, the number and amount of natural sellers (e.g. homeowners, house-flippers, and smaller construction companies) dwarfs the number and amount of natural longs, leaving speculators to pick up the balance. Speculators probably seek entry points (on any investment) w/ favorable risk/reward trade-offs (i.e. buying at a discount to expected values). However as contracts shorten toward settlement, the price of futures and index values must converge. Here, I've used prices on the X20 (Nov 2020) contract. The contract had ~1.8 years to run at the end of 2018 and has about 0.8 years until expiration today. I'd imagine that cutting the time-to-expiration by more than half would tend to find futures trading at less of a discount to expectations. Should expectations have remained unchanged, futures prices would have had to rally -consistent with the above results. (A note, bid/ask spreads also tend to compress as time-to-expiration shortens. In a rising market, such as 2019, the most recent bid is often the trigger for closing prices^3.
My concern is that each of these three components moved dramatically (stocks up 30%, interest rates down 16%, and the time-to-expiration cut by more than half) and yet home price futures gained "only" 2-4%. What's to happen in 2020 should home price contracts not have the same tailwinds? I pose this as a somewhat rhetorical question, compounded by the notion that the gain in home prices has extended into record duration.
Feel free to contact me if you'd like to discuss this blog, contribute to the debate as to where home price futures are heading, have a question on hedging with home price index derivatives, or to propose a trade.
Thanks, John
^1 As an aside, I've followed this correlation for years, and when I reach risk limits, have used an 8:1 or 10:1 ratio between stock futures and home price futures.
^2 You could have a vigorous debate both between academics and nascent co-investment companies as to whether the return on homes should be viewed as the price return, or the leverage return (net of mortgages).. That is a 3% gain in home price would translate into a 15% gain on a 20% equity investment. I leave that for another blog, or for others to champion.
^3 The rule for determining the close on CME Case Shiller futures contracts is: the last trade price, or a subsequent higher bid, or lower offer. As such, even if there have been no trades, higher bids (than the last trade) will result in higher closes. A focus of mine over the last year has been to keep bid/ask spreads tight on the X20 contract, and to treat it as my benchmark contract. As such, I've been more likely to raise bids/lower offers than by Dec 2018, with the rise in markets leading (probably) to more bid raises -which increased closing prices.