by Calculated Risk on 11/12/2012 12:08:00 PM

From Chris Flanagan and Michelle Meyer at Merrill Lynch: Another upward revision to home prices

Back in March, we called the bottom in national home prices. It appears that while we are correct on the timing, we understated the magnitude of the turn. We revised up our forecast in August, but did not go far enough and hence are revising our trajectory again. We now look for S&P Case Shiller prices to be up 5.0% YoY this year (Q4/Q4), compared to our prior forecast of 2.0%. ... Taking a longer perspective, we look for average home price appreciation of 3.3% over the next ten years or a cumulative gain of about 36%. This will modestly outpace the rate of inflation.

Our forecast still assumes some slowing in home prices into the end of the year. We forecast S&P Case Shiller national prices to be up 5.6% q/q saar in Q3, following a 9.3% gain in Q2. We look for essentially flat prices in Q4 and a decline of 1.6% in Q1 before prices resume their upward trend. It is important to remember that the housing market is subject to volatility in the best of times; in this distorted market, we cannot expect a smooth pattern.

The key factor driving the increase in home prices is a better alignment of housing supply and demand. Inventory of homes for sale has declined markedly. On an absolute level, listed inventory is at the lowest since 1Q05. And even after accounting for the slow pace of sales, it only takes 5.9 months to clear inventory. Supply is even lower for new construction homes ...

While the initial turn higher in demand was driven by investors, it appears that more recent gains can be attributable to primary homebuyers. The latest results from the Campbell HousingPulse survey shows an increase in the share of sales to current homeowners and a decline in investor share over the past few months ...

And on the economic impact:

The gain in home prices will support economic growth. The traditional way we think about the link between home prices and the economy is through the "wealth effect." The wealth effect captures the amount of additional spending power created (lost) from an increase (decrease) in household wealth. The conventional wisdom is that the marginal propensity to consume out of housing wealth is about 3 to 5 cents per dollar over a three year period. This suggests that the gain in housing wealth will only be a gradual tailwind for the economy.

There is also another important link which can show up more quickly – consumer confidence. The turn in home prices, although modest at the start, will help to boost consumer confidence. Simply believing that prices have stopped falling should provide a sense of relief to households. It will also allow households to have greater mobility, generating a more efficient labor market and greater churn in the housing stock. We have already seen a turn higher in consumer sentiment, which is likely correlated with the gain in home prices.

CR Note: Merrill Lynch analysts are using the quarterly Case-Shiller National index (most reporting uses the monthly Case-Shiller Composite 20 index). The Case-Shiller National Index was up 1.1% in Q2 (compared to Q2 2011).   Looking at the recent monthly data, Merrill's forecast for 2012 appears about right.

Merrill analysts are expecting prices to increase 3% in 2013. My guess is most of the sharp decline in inventory is now behind us, and I think there are many potential sellers waiting for a better market, and slightly higher prices will probably mean a little more inventory keeping prices from rising quickly.

Note: I wrote about The economic impact of a slight increase in house prices back in August.

Also note the comment about more "primary homebuyers" - that is an important transition along with more conventional sales (as opposed to foreclosures and short sales).