John Paulson made $20 BN by betting against the US Sub Prime market mortgage market in 2007 & 2008. His portfolio manager Paolo Pellegrini convinced Paulson to make the bet based on a key chart. Here is what it would have looked like if we did the chart (via Calculated Blog):
Here is the background on the chart from Gregory Zuckerman from the Wall Street Journal who wrote the book, the Greatest Trade Ever.
Mr. Pellegrini spent hours in Mr. Paulson's office, debating how to deduce a turn in the housing market. Mr. Paulson charged Mr. Pellegrini with figuring out whether homes were, in fact, overpriced. Late at night, in his cubicle, Mr. Pellegrini tracked home prices across the country since 1975. Interest rates seemed to have no bearing on real estate. Grasping for new ideas, Mr. Pellegrini added a "trend line" that clearly illustrated how much prices had surged lately. He then performed a "regression analysis" to smooth the ups and downs.
The answer was in front of him: Housing prices had climbed a puny 1.4% annually between 1975 and 2000, after inflation. But they had soared over 7% in the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40% to return to their historic trend line. Not only had prices climbed like never before, but Mr. Pellegrini's figures showed that each time housing had dropped in the past, it fell through the trend line, suggesting that an eventual drop likely would be brutal.
"This is unbelievable!" Mr. Paulson said the next morning. The chart was Mr. Paulson's Rosetta Stone enabling him to make sense of the housing market. They had to figure out how to profit from it.
The next time you see a massive run up in house prices but don’t see a corresponding increase in income levels, be very wary. For example, take a look at this chart in Melbourne, Australia. The chart shows the run up in house prices but also the the levels of income consumed by mortgage payments.
The very interesting part about this chart is the data is only till 2010. In the intervening 3-4 years, the data has only gotten worse. Here is an excerpt from a news article from June 13 2014:
MELBOURNE has just experienced its fastest property boom since the turn of the century, according to new analysis from the Real Estate Institute of Victoria. The boom has added a median $104,500 to house prices in just nine months after prices leapt almost $35,000 (6.3 per cent) every quarter (three months) from June last year to the end of March this year, according to the REIV figures.
Who is looking at the $20BN dollar version of the Melbourne chart?
But, will anybody listen?