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Shares vs houses

Created:

21 August 2009

Updated:

24 August 2009

Written by:

Chris Dillow

Despite their 20 per cent rise since March, shares are still cheap by one measure - if we compare them to house prices. The ratio of house prices (on the Nationwide's index) to the All-share index is still 22 per cent above its post-1980 average.

In many ways, this is surprising. Of course, there are good reasons why shares should be cheaper now than a few years ago: economic risks are much higher, and it's possible that the recession has done lasting damage to our growth rate. But these are also reasons for house prices to be relatively low too. If people anticipate weak income growth and lots of volatility and uncertainty, they should be reluctant to take out big mortgages even if they have the opportunity to do so, And that should depress house prices.

Nor is it the case that a high ratio of house prices to share prices is justified by the Bank of England's loose monetary policy. Yes, super-low mortgage rates, for those who can get them, are supporting house prices. But low interest rates and the fact that the Bank is throwing money at institutional investors should be good for shares, insofar as some of the cash raised by selling gilts to the Bank might eventually find its way into the stock market.

What's more, there's one reason why shares should be high relative to houses, rather than vice versa. The entry of China and India into the global economy has created a huge supply of cheap labour - and not just unskilled labour. This should tilt bargaining power away from workers and towards employers, and so raise profits at the expense of employees. And this is happening. Whereas unemployment is at its highest rate since 1996, and expected to go higher, non-oil, non-financial companies' returns on capital are still better now than they were in 2001, despite the savage recession. Because shares are a claim upon profits whilst house prices depend more upon wage incomes, this fact should boost shares relative to house prices.

So why are shares cheap relative to houses? One possibility is that the stock market has got it wrong, and shares have become irrationally cheap.

The evidence for this is that, historically, the house-share price ratio has tended to mean-revert; when shares have been low relative to house prices, they have subsequently tended to rise relative to them. Since 1965, the correlation between the house-share ratio and subsequent three-year moves in it has been a statistically significant minus 0.4.

Surprisingly, all of this mean reversion has come through share prices, not houses. The house-share ratio has been insignificant as a predictor of three-year changes in house prices; since 1965, the correlation has been a mere minus 0.1. But it's been a nice predictor of three-year changes in the All-share. The correlation has been 0.61, with the ratio alone able to explain, in the statistical sense, almost two-fifths of the variation in three-yearly returns on shares since 1965.

If this relationship continues to hold, it points to the All-share index rising 45 per cent in the next three years.

Of course, historic relationships can break down. But this leaves us with the question: why should house prices remain unusually high relative to shares? The answer's not obvious, especially in an economy where unemployment is high and rising.