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Don't get too optimistic about the housing market

The current housing market is emblematic of the effect that ultra-low interest rates have had on the economy at large. Low interest rates have inflated the economy just as they have inflated housing prices. In other words, the economy has become heavily dependent on low interest rates, and nobody can predict what will happen when the training wheels are removed.

S&P Case Shiller's latest 20-city home-price index, which is a value-weighted average of 20 metropolitan area indices within the United States, rose 4.6 percent year-over-year in January. This is good news for those of us whose biggest investment is our home. The growth rate in home prices had been slowing sharply in recent months, but the latest data may provide some hope that this trend has stopped — at least for now. In the table below, we show the YOY growth rates in home prices over the past nine years.

Source: S&P Case Shiller

The growth in home prices since early 2012 has been largely due to dramatic improvements in affordability. Fortunately, the National Association of Realtors (NAR) produces an index to measure changes in housing affordability over time. The NAR's index is comprised of three inputs: median home prices, median household incomes, and mortgage rates. Affordability is positively correlated to household incomes, and negatively correlated to both mortgage rates and housing prices.

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Below we show the negative relationship between housing affordability, and mortgage rates and housing prices. As mortgage rates and home prices fell during the several years prior to 2012, home affordability skyrocketed. In fact, the NAR's affordability index more than doubled from a low of about 103 in the second quarter of 2006 to a high of 207.3 in the first quarter of 2012. The dramatic improvements in affordability attracted buyers to the housing market. As a result, housing prices bottomed and started to rise beginning in early 2012. More recently, however, the affordability index fell abruptly in mid-2013 and has been hovering at a level of 160-175 ever since. The reduced affordability reflects both higher housing prices and higher mortgage rates compared to 2012 levels.

Sources: Freddie Mac, S&P Case Shiller and National Association of Realtors.

A recent article in the Wall Street Journal ("Spring Puts Bounce in Housing Market", by Spencer Jakab) discussed the positive housing-price data from S&P Case Shiller. Jakab attributed the stabilization in home-price growth to both lower mortgage rates (compared to a year ago) and looser credit conditions (federal agencies have relaxed the criteria for obtaining a mortgage). However, at the end, he cautions that, should 30-year mortgage rates go up 1 percent in the next year and housing prices rise 5 percent in that time, then a monthly mortgage payment would climb by a whopping 18 percent.

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This is a fairly shocking statistic that supports our thesis that the economy's growth potential is capped for the foreseeable future. Growth in an economy as heavily dependent on loose credit conditions (read: low interest rates) cannot possibly be expected to accelerate if/when interest rates start to rise, even moderately. To illustrate our point further, the chart below shows the results of a regression analysis we did using the two most important determinants of housing affordability — housing prices and mortgage rates — to predict the NAR's Housing Affordability Index through 2016.

The blue line represents actual historical levels for the Housing Affordability Index as reported by the NAR. The orange line represents affordability levels produced by us through regression analysis using 1) actual historical data for mortgage rates and housing prices through the fourth quarter of 2014; and 2) assumptions for mortgage rates and housing prices for 2015 and 2016. If we make the assumptions that 1) housing prices grow 5 percent annually in 2015 and 2016; and 2) mortgage rates drift 1 percent higher in equal increments through 2016, then our regression predicts that the affordability index will decrease to about 140 (a level last seen in 2008) by the end of 2016. Does anyone believe that housing prices will keep going up if we are face with another 16-percent drop in affordability on top of the 23-percent drop since the first quarter of 2012? I sure don't.

Sources: The National Association of Realtors Housing Affordability Index and regression analysis by Farr, Miller & Washington

For our part, we think it makes sense to temper our enthusiasm about the economy for a while. Remain invested, but remain defensive!

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Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.