Don't Buy Housing Bubble Propaganda

When we compare what the key drivers are for price appreciation between these two asset classes, other crucial differences appear.

What Drives Housing Prices

We can look at three key drivers for equity price appreciation over different time lines: Longer term, it's a function of earnings. Higher profits support greater prices at historical P/E ratios. Multiple expansion and contraction occurs as a function of our next two drivers. Intermediately, macroeconomic conditions (aka the business cycle) drive the entire market. I expect the cycle, which began post-2001 recession, to end in early 2006. If that's correct, then prices will retreat as revenue and earnings slow. Over the short term, sentiment -- especially when it gets to extremes -- is a key mover.

Housing is driven by very different factors. First and foremost are mortgage rates. Something I have yet to hear the pundits opine on is that most home buyers don't care what they pay for a house. That's right, you read that correctly -- purchase price doesn't matter. What they do care about is the monthly carrying costs. For the vast majority of home purchasers, the biggest variable in that will be their mortgage rates.

The first house I owned had a $300,000 mortgage. Back when interest rates were near 10%, the monthly payment would equal $2,632.71. If a buyer today were to finance the purchase of that home for $500,000, at a 6% mortgage (and you can get lower rates today), the monthly payment is $2,997.75. That house appreciated 67%, yet the mortgage payments went up only 14%. This helps demonstrate why a big drop in mortgage rates drives prices much, much higher. And that's not counting the buyers who made larger than 10% down payments via the accumulated equity from the sale of their prior homes. (See this mortgage calculator to run your own numbers.)

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback; click here to send him an email.