A Question of Overcorrection

Everybody agreed that house prices were overvalued before they began to fall more than 18 months ago. The question was how they would work off that overvaluation: gradually or suddenly. The financial shock, coupled with the abrupt withdrawal of mortgage finance, was big enough to give us a rapid correction.
So where are we now? How much overvaluation is left? The Nationwide building society suggests that, by the end of last year, “real” inflation-adjusted house prices, at an average of £156,828, were just over £5,000 above the long-term trend . The further fall in prices during the early part of this year has closed that gap, which means that house prices are now back on trend.

The Halifax, meanwhile estimates the house-price-to-earnings ratio (average house prices against average male full-time earnings) at 4.34. This puts it within 9% of the average since 1983 of 4. Some criticise the Halifax’s measure, but it is one of the few that has been calculated on a consistent basis over time.

Some will say the Nationwide and Halifax are vested interests. What about the International Monetary Fund? It famously said UK house prices were 30% overvalued, which means they needed to fall 23% to get back to correct value (work it out). The falls recorded by the Halifax and Nationwide suggest we are pretty close to that point.

Life would be a lot simpler, of course, if the market neatly corrected an overvaluation and settled on its long-term trend. In the real world, however, overvaluations lead to periods of undervaluation. The rise from the mid1990s was from a position in which prices were undervalued by a record amount.

How big an overshoot might happen this time? The freeze on mortgage finance is thawing, but we are not yet at the end of the process. The Halifax’s house-price-to-earnings ratio provides a guide: it has fallen by 26% so far in this correction, against 38% in the early 1990s.

The pattern then was that it dropped sharply at first in the recession, as prices fell and earnings continued to rise at a strong rate. It then fell gradually for about three years as prices stagnated and earnings grew, albeit at a slower pace. History never repeats itself exactly, but it does provide useful clues.

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