In a note to clients, Goldman Sachs (GS) looks asset prices in housing and equity markets, given that equity markets are back at near-historic highs and some are sounding the alarm about a potential housing bubble.
Goldman notes that the main predictors of busts are past asset price appreciation and past credit growth, followed by a rising investment/GDP ratio for stocks and high inflation for housing.
“Our model says that the further US equity price gains of 2014 have pushed the risk of an equity bust back up to roughly average levels. The risk of a housing bust remains very low,” Goldman tells clients. “The main factor holding down the risk of another bust, especially in the housing market, is the weakness of credit growth since the crisis.”
Goldman’s analysts’ broader view is that the risk of an asset market bust – especially of the recessionary variety – remains relatively low.
“Although the current expansion has already lasted longer than the median expansion, we still seem to be quite far from the inflationary overheating or financial imbalances that historically precede most US recessions,” they say.
“To recap, our analysis uses quarterly data for 20 advanced economies on house prices, equity prices, and a set of economic and financial variables that have been found to correlate with the risk of future busts,” they note. “We define an equity bust as a year-to-year decline in the quarterly average of real equity prices of at least 20%, and a housing bust as a decline of at least 5%. If the condition for an equity or housing bust is met in quarter t, we date the crisis as having started in quarter t-3. A recessionary bust is defined as a bust that involves a year-to-year decline in real GDP either in the same quarter or up to four quarters later. A deeply recessionary bust additionally requires that the year-to-year decline in real GDP exceed 2%. Our empirical analysis then tries to identify economic and financial variables that predict–or generate and ‘alarm’–for a bust 5-9 quarters later.”
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Starting with equity busts, this first graphic above shows that the single most important predictor is past equity price appreciation, followed by a rising investment/GDP ratio and high equity volatility, Goldman says.
“Our interpretation is that many equity busts are simply the counterpart of prior periods of strong price appreciation, and in this context it is not surprising that big moves downward are more likely when volatility is high. The sizable effect of a rising investment/GDP ratio may reflect a negative impact from excessive capital spending on corporate profitability or the broader dangers posed by an unsustainable homebuilding boom,” they say.
But these results change in important ways when we focus on recessionary equity busts. Past price appreciation is now somewhat less important, but credit growth is much more important and the role of equity volatility actually switches sign. As such, they note, recessionary equity busts are more likely to follow low equity volatility.
This graphic above also shows that the most important predictor of house price busts, according to their research, is the change in the credit/GDP ratio over the prior five years.
They note that house price busts have also tended to follow periods of high inflation, high equity volatility and large current account deficits, although all of these effects weaken at least somewhat when their analysts focus on recessionary busts.
“Our regression model used data through the end of 2013, but we can now update the results through the middle of 2014. So what do these updated models say at the moment?,” they write.
The next two graphics below show indices of the risk of an equity and housing bust in the United States, calculated as the current probability of a bust divided by the 1985-2013 average.
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“The risk of an equity bust has risen back to roughly average levels, while the risk of a housing bust remains very low. The main factor holding down the risk of another bust, especially in the housing market, is the weakness of credit growth since the crisis,” they say. “Stepping beyond the model itself, our broader view is that the risk of a recessionary asset market bust remains relatively low, and probably lower than the equity bust model by itself would imply. The expansion has already lasted longer than the median expansion historically, but we still seem to be quite far from the overheating or financial imbalances that historically precede most US recessions. Thus, we expect the current expansion to last longer than average and view the risk of recession over the next few years as fairly modest.”