Jeffrey Gundlach, the chief investment officer for TCW recently told clients that the current credit and housing slump may not subside for several more years.
His thesis is that mortgage default rates will continue to worsen as housing prices fall. Due to this, the S&P 500 could fall another 30% and housing may not bottom until 2014.
Is this a likely outcome? In thinking through this yesterday evening, I believe this scenario is possible. Let me explain…
Over time, markets tend to revert to their long-term average return. This is best illustrated with a graph:
This chart shows the NASDAQ over a 30 year period in dark blue and the light blue represents the long-term average return. With this, it’s easy to see that the market tends to bounce up and down along the long-term average.
However, take a look at the tech bubble, which can be seen toward the right-hand side of the graph. The issue is this: When markets correct, they tend to overshoot the long-term average in the opposite direction. So, if the market is over-valued, it will go through period where it’s under-valued and vice-versa.
Back in June, I posted another chart that shows the degree to which houses were overvalued in select markets:
As you can see, in some cases, they were overvalued by a factor of 2 or more, which implies that housing prices may need to fall by as much as 50% or more in total.
So what does all this mean? Simply stated, as the housing bubble deflates, we could go through a period where housing is actually undervalued relative to its long-term trend. The degree to which housing prices slump will have a direct impact on the value of the financial instruments currently held by Bank of America, Washington Mutual and other banks. As such, it’s possible that they may have to book losses associated with this under-valuation. And this process could take some time.
While it is possible, however, I do not know how likely it is to happen.
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