I just finished reading the latest edition of one of my favourite publications, Grant's Interest Rate Observer, Vol 26 No 18, dated September 19, 2008.

In a piece on the desirability of investments in certain mortgage structures, Grant's discusses the state of the current housing market. 

The piece references three metrics for determining home price valuations.  The first is the recent transactional value of home prices relative to GDP.  According to this metric, home prices are undervalued.  However, I do not believe transactional value relative to the economy is a good indicator of valuation any more than I believe the dollar trading volume of a stock relative to its equity market capitalization, though it may be a good indicator of sentiment.

The second indicator referenced is the ratio of rental income to home prices.  Since 1960, rents have averaged 5% of home prices.  At the end of the second quarter, rental yield to home prices was 4.0%-4.1%.  If rental prices do not rise, home prices have to fall 18%-20% so that rental yields are back to long-term trend.

The final indicator cited was incomes to home prices.  Similarly, home prices would have to fall another 18%-21% for houses to be back to their long-term trend relative to income.

What is perhaps most striking is that generally, asset markets do not deflate to trend.  They usually over-shoot to the downside so that they become cheap.

I do not believe the decline in home prices has stopped, nor do I think RTC II will halt the decline, though it may mitigate the downdraft. 

Perhaps home prices will not fall another 20%, given that rentals and incomes may rise and RTC II may cushion the fall.  However, what happens to the financial system if home prices fall another 10%?  Or 15%? 

If home prices have further to go to the downside, there are more asset impairments within the financial system to come, and economic growth will be anemic at best and in contraction at worst. 

I use 7.5% as a normalized profit margin, which is above the long-term average of 6% (and down from the peak of 10% last year).  Thus, my approximate normalized earnings estimate for the SP 500 is $75.  That gets me to a normalized multiple of 16x, which is not cheap.  It's as if investors believe this is a normal economic environment.

Given that investors are valuing the market as if the credit crisis isn't really happening; given that the market has fallen 25% from its peak, which is less than the average post-World War II decline of 30%; and given that I keep hearing from the talking heads and the powers that be this is the Greatest Credit Crisis Since the Depression, this is not a good environment for stocks.

Thus, the bear market in equities will continue.