Household real disposable income fell by 0.8% in 2010 but real wealth gained an estimated 2% to stand only 6% below its 2007 high. A rising wealth to income ratio should maintain downward pressure on the saving ratio, supporting consumer spending.

Household net financial wealth – the market value of financial assets minus debt – grew by 10.1% between end-2009 and end-2010, according to National Statistics figures published last week. This reflected a capital gain on equities and corporate bonds held within life assurance and pension schemes, supplemented by additional saving.

Total wealth includes housing. Official 2010 figures on housing wealth have yet to be released but the Department of Communities and Local Government house price index – a key input – rose by 3.7% in the year to December. Assuming the same increase in the value of the housing stock, total wealth grew by 6% or a real 2%.

This 2% rise follows a 9% gain during 2009, implying that real wealth has retraced two-thirds of its 15% decline during 2008 – see first chart. The ratio of wealth to annual disposable income was an estimated 7.0 at the end of 2010, a level bettered in only two previous years (i.e. 2006 and 2007). The wealth to income ratio is inversely correlated with the saving ratio so the rebound supports expectations that a further fall in the latter will insulate consumer spending from income weakness this year – second chart.

The consensus view that housing remains significantly overvalued reflects the high level of the house price to average earnings ratio. A national accounts version of this metric is the value of the housing stock divided by aggregate household disposable income. This stood at 4.31 at the end of 2010, 52% above the average of 2.84 since 1965 – see first chart.

The "equilibrium" level of prices relative to earnings, however, has trended higher over time as rising demand – due to an expanding population, a fall in average household size and the tendency to spend more on accommodation as income increases – has clashed with inelastic supply. The housing stock / aggregate income ratio at the end of 2010 stood 5% below a log-linear regression line – first chart.

A superior valuation metric is the ratio of prices to rents or its inverse, the rental yield. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

A national accounts version of the rental yield is the sum of actual and owner-occupied imputed rents divided by the value of the housing stock. This finished 2010 at 3.56% – almost exactly in line with its average since 1965, of 3.57%.

The yield reached a low of 2.77% in September 2007, consistent with house prices being overvalued by 29% (the percentage deviation of 3.57 from 2.77). This excess, however, has been eliminated by a combination of a 5% fall in prices – according to the Department of Communities and Local Government index – and a 24% rise in rents.

The statement that housing is not expensive does not, of course, preclude a fall in prices to an undervalued level, for example if a shock to household income resulted in forced selling. Displaced owner-occupiers, however, would add to the demand for rented accommodation. Any downside for prices from current levels is likely to be temporary and limited as long as rents continue to increase solidly.