How can we identify bubbles in asset prices? Well, it's certainly not easy and there's hardly a clear mathematical or statistical basis for identifying bubbles.
Many economists and financial wizards like to say bubbles are best identified by observation and social condition, not just numbers and data. Just because something is expensive as reflected in numbers doesn't mean that asset is in a bubble.
Robert Shiller, a renowned economist and researcher in financial matters, calls bubbles "a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors … despite doubts about the real value of an investment."
There are a few keys words in this wise observation: investor enthusiasm, psychological contagion, amplifying stories, and justify the price increases.
Some of Shiller's statement could be restated as: the wide acceptance of a new paradigm. There is a new reality or things have permanently changed. Things will not go back to the way it was because prior assumptions or beliefs were incorrect.
Do We Have A Housing Bubble?
If you've read my blog for any period of time, you will know I am super cautious about our housing market. I no longer own a house and I don't invest in real estate. This is mostly because I believe our housing market is in a bubble and has been for some time.
Of course, just because something is in bubble territory doesn't mean that prices will immediately correct. Bubbles can grow and grow and grow. This is why it is so difficult to identify them.
But there are a few indicators in our housing market which are consistent with Dr. Shiller's statement regarding bubbles.
Investor Enthusiasm: A few months ago John Pasalis, a real estate broker in the GTA, identified that nearly 30% of all real estate purchases in the Toronto area were made by investors. Pasalis openly states his numbers are very conservative as he can only track those properties which are put up for rent on MLS after purchase. He doesn't include the private rentals, Kijiji ads, and investors who choose to leave their homes vacant while waiting for price increases to pay off.
By his calculations, Pasalis estimates a whopping 95% of these investment properties are losing money every month on a cash flow basis. Investors are counting solely on the expansion of property value to provide them with profits while willingly forking over money every month.
It's getting increasingly difficult to argue the real value of investing in real estate given these poor return conditions.
Psychological Contagion: Talk to your friends and read the news to figure this one out. It seems that all anyone can talk about is real estate. The value of their house. Their friend who owns 2 investment condos. Obsession about interest rate changes. The 4 people in their friend/acquaintance circle who are Realtors, flippers, or mortgage gals. The money everyone is making in real estate. The price of the house that just sold down the street. Especially in much of B.C. and Ontario, all anyone ever talks about is real estate. When everyone thinks the housing market is a foolproof money-making machine, you should be nervous – nothing is foolproof, especially when it comes to investing.
Amplifying Stories: These tales of easy money yet to be made might be the most damaging. Like politics, it seems if a story or baseless theory is repeated enough it becomes almost true. While I was on vacation in B.C. a few weeks back – a place where people are more deluded than most – I heard an incredible story where a Realtor suggested to a buyer that house prices in this small city will double in the next five years. Incredible considering average house prices in this area have increased by 40% over the last 7 years – in some of the hottest market conditions ever seen.
This individual, clearly driven by self-interest, is spreading the message to buy now because there's super easy money to be made. Buy a house now for $500,000 with 20% down. Sell in 5 years for $1 million. Get on board for an easy 10-bagger. It's an easy sell to the herd where house prices soared in the past few years and the message is coming from a "professional". Don’t be a herd animal.
Justifying Prices: This is the typical stories that are spread to logically attempt to explain absurd price run-ups. Buyers from China, land shortages, immigration, permanently low interest rates, Airbnb rentals, and any other number of mostly sensational stories
The reality is prices are not determined by these factors save for a few exceptional circumstances or conditions. I can think of places like Hong Kong, Singapore, Monaco, and some Caribbean Islands where these exceptional factors are a reality. In Canada, prices over the long run are limited by household income and interest rates.
Is the Bubble Going to Pop?
All bubbles pop. In fact, I'm not aware of a bubble anywhere that "softly-landed" as most real estate dudes will grudgingly suggest is a worst-case scenario, bankers sell as a likely scenario, and politicians believe they can actually engineer.
It might be bold of me, a writing nobody with no important titles or letters behind my name, to suggest that I know better than all these important folks. But I would ask any one of them to point me to an example of a bubble that slowly, gently deflated.
During the tulip bubble of Golden Age, 17th century Holland, a single rare bulb would trade for more than a luxury mansion in Amsterdam – the New York City of the day. In the span of a few months the value of bulbs collapsed by a factor of 10!
In the South Sea Co. bubble of 18th century Britain, share prices soared over a few years and suddenly collapsed to about 1/10th of the value in just 6 months. Famously, Isaac Newton got swept up in this bubble and lost a fortune.
These are extreme, history making examples. But what about the much closer, more comparable U.S. housing bubble of the mid-2000s? House prices in the U.S. doubled in about 7 years from 1999 to 2006. Over the next 6 years, prices fell by more than 1/3rd – bringing prices back to 2003 levels. Millions had their entire net worth wiped out in one big whoosh.
By almost every measure, house prices in Canada are even more extreme than they were in the U.S. at the peak of their bubble. If prices were to fall by 35%, the average house in Canada would fall from $504,000 to $327,000. I can only imagine the fear and anxiety in the market in those conditions. What would your place be worth?
I strongly believe now is a time to rent in most Canadian markets. If you have a place with lots of equity and diversified investments outside of your residence, you'll be fine. If all your bets are on your house, you should seriously think about diversification now.
Check out my Rent vs. Buy calculations to help you decide if buying is right for you.