Where's this Housing Bubble we've been hearing about?

Back in 2002 we heard the first of the rumblings.  Stocks were down big from their highs, and real estate prices had begun what turned out to be the early stages of a huge run up in prices.  It was quiet at first, as most of the media was focused on the impending war in Iraq, the Enron accounting scandal, and the massive deterioration of stock prices.

But sure enough, there were a few who were beginning to say, "wait a minute.  Real estate prices have gone up a lot in some areas over the last few years.  Maybe that's the next bubble."

It's funny because the very idea of an asset price bubble had only recently become part of the American nomenclature.  Only a few years earlier, in the late 90s, it had become widely preached that asset bubbles were a thing of the past.  Whether technology was credited, investor sophistication, freedom of information, efficiency of markets, many believed that we would never again experience a stock market decline like 1929, 1974 or 1987.

Then the unthinkable happened.  Stocks declined.  "Just be patient, don't panic," the same people assured everybody.  "you haven't lost any money until you sell," they philosophized.  Believe me, you had lost money.  It's like telling somebody who walked up to a blackjack table with $100, finding themselves down to $20 in chips, that they haven't lost anything unless they get up from the table right now.  No, they have lost real money.

All of a sudden something different happened.  Instead of predicting that bubbles were a thing of the past, everyone wanted to be the one to predict the next bubble.  Well, real estate prices had been increasing, especially in coastal cities.  It was a fairly natural target.  But were they wrong?

Many in the housing industry, like David Lereah, the Chief Economist for the National Association of Realtors, would point to the fact that there have been talk that a housing bubble exists, may exist or is forming, as early as 2002 as evidence that one does not currently, nor ever did exist.  Truthfully, the real estate bubble talk didn't really pick up steam until sometime around early 2004.

Of course, that's faulty logic to begin with.  As asset bubbles go, they typically extend valuations beyond what economics or logic allows.  It is generally a condition created under the widespread belief that prices will continue to inflate, thus today's high prices are acceptably low compared to tomorrow's even higher prices.  Call it the "greater fool" theory, a house of cards or a pyramid scheme, we are talking about the same thing.  What typically happens is that prices don't just go past reasonable valuations, they sail WAY past them.  And it goes on for longer than most would estimate.

Look again at stocks.  Most people remember former Federal Reserve Chairman, Alan Greenspan's speech in which he noted that there was "irrational exuberance" in the stock market.  Most remember only those two words, and assume it to mean that Greenspan was calling the stock market a bubble at that time.

There are two important things that most people don't know or remember about that quote.

First, what did he really say?  Again, most assume that it was a "Greenspanism" for "a stock market bubble exists."  It's certainly open for interpretation, but in that speech, he was asking a question.  "how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"  He went on to say that even if a collapsing asset bubble exists, but does not threaten the real economy, production, jobs or price stability, then the Fed need not be concerned.

Second, WHEN did he say it?  Those (in)famous words were uttered during his speech at a dinner that took place on Deceber 5, 1996.  That same day, the Dow Industrials closed at 6,437 and the NASDAQ closed at 1,300.

In the years after that speech, prices continued to climb, and to have heard those words in Deceber 1996, and pulled all of your money out of the stock market would have cost you considerable potential gains.  The Dow closed at an all time high of 11,722 on January 14, 2000 with an intraday high of 11,908.50.  The NASDAQ closed at an all time high of 5,048.62 on March 10, 2000 with an intraday high of 5,132.52.  As of today's writing, the Dow closed at 11,584.54, very close to the all time high.  The NASDAQ closed at 2,344.99, still less than half of the all time high.  Today's close for BOTH market indices, however, was still higher than their level on the day of Greenspan's speech.

So, given that, you should have ignored Greenspan then, right?  Just as now, you should ignore those who claim that there exists a real estate bubble.  Well, let me continue.

Those who began uttering the words "real estate bubble" in 2002 were clearly early to the game, much as Greenspan was in 1996.  But remember, Greenspan did not outright say that stocks were experiencing a bubble, rather asking if they were.  Likewise, the quiet rumblings in 2002 about the real estate market were mostly asking the question, "Stocks are down big, is real estate next?"

Just as stock prices continued to ascend at a rip-roaring pace in the three years following Greenspan's speech, so have real estate prices in the three years that followed the early warnings.

As illustrated by the massive differential in how much the NASDAQ went up versus the Dow on a percentage basis from 1996 to 2000, the entire stock market does not simply go up or go down together in concert.  Certain sectors or asset classes move up more and faster at times, and are likely to be more susceptible to faster and more dramatic downturns as well.  Everyone knows that tech stocks, particularly dot-coms, led the way up AND down in the late 90s and after the bursting of the bubble in 2000.  Likewise, while there has been a nationwide increase in real estate prices, certain areas, particularly the coastal regions, have certainly led the way up.

It is when prices reach a peak that investors become willing to take additional risk in order to maximize gains.  Investors used more margin debt to buy stocks in early 2000 than any time since securities regulations put limits on these things in the 1930s.  And over the last couple of years the use of no or low down, ARM, interest only and negative amortization loans have increased remarkably.

I'm not saying the bubble is about to burst, or that prices will decline anywhere near the magnitude that stocks did.  But would you rather have listened to Greenspan in 1996, or James Glassman, author of Dow 36,000, published in October, 1999?  In the introduction of Glassman's book he notes, "The Dow should rise to 36,000 immediately, but to be realistic, we believe the rise will take some time, perhaps three to five years."

I would act with caution.

Also this disclaimer:  This is not advice of any nature. You should consult with your own financial advisor before making any major financial decisions, including investments or changes to your portfolio. LA Money Guy is not responsible for any losses, damages or claims that may result from your financial decisions.

Comments

[Andrew - Money Supply & Debt Blog]

The real estate bubble is already deflating in certain markets, specifically Florida and California. Foreclosures are way up, prices are dropping, and there is an excess inventory.

However, the way a lot of people have painted this picture is that there is an across-the-board bubble. The fact is certain markets have inflated way beyond their means with prices largely supported through speculation. Markets can only support so many sellers, and when the number of sellers outpaces buyers prices drop.

It appears that the drop of prices in California and Florida are triggering rises in other markets, such as Texas, where people are "fleeing" to.

As far as an "across the board bubble", a big part of this will be interest rates. At this point it starts getting very, very complicated and I don't believe anyone can make a blanket statement one way or the other.

The bottom line is that if you are buying real estate right now you should be looking for foreclosures and buying under market value -- or be willing to cover losses out of pocket for a few years.

Long term, we are in an inflationary environment and prices will continue to appreciate practically indefinately (short of some disaster scenarios, just ask Argentina about that one.)

[Bronco]

Glad to see you finally posting on the real estate bubble. Bubbles always last longer and go higher than any logic would support. But we are in an unprecentented scenario with exotic loan structures and historically low rates. This will be a bloody, bloody mess that will trump the DOW free-fall (probably not NASDAQ tho...)