One of the most ironic and fascinating characteristics about an asset bubble is that central banks claim they can’t recognize one until after it bursts. And Wall Street apologists tend to ignore the manifestation of bubbles because the profit stream is just too difficult to surrender.
The excuses for piling money into a particular asset class and sending prices several standard deviations above normal are made to seem rational at the time: Housing prices have never gone down on a national basis and people have to live somewhere, the internet will replace all brick and mortar stores, and perhaps the classic example is that variegated tulips are so rare they should be treated like gold.
I am willing to let the Dutch off the hook; back in the seventeenth century asset bubbles were virtually nonexistent because money was still in specie. But central banks have created the perfect petri dish for asset bubbles over the past three decades. Therefore, it’s imperative for investors to understand the classic warning signs of a bubble so you can avoid the inevitable carnage in the wake of its collapse.
As I identified in my book “The Coming Bond Market Collapse”, there are three classic metrics to determine when an asset has grown into a bubble: it becomes extremely over supplied, over owned and overpriced compared to historical norms.
The real estate market circa 2005 was a great example of a classic bubble. The supply of new homes boomed as new home construction rates peaked around 2 million units per annum in the middle of the last decade. That’s about 400k units higher than what would be considered the historical average.
Just prior to the start of the Great Recession the level of home ownership in the U.S. soared. This rate hit a high of 69% in during 2005, after bouncing around 64-66% for decades. Today’s home ownership rate has fallen back to just 63.7%, which is the lowest in 25 years.
And finally, during the real estate bubble homes were massively overpriced. According to Trulia, at its 2006 peak home prices were 39% overvalued based on consumer incomes and cost to rent. On a national level the median home price to income ratio shot to 4.7 in 2006, compared to the 2.6 historical average. The current home price to income ratio has climbed back to 4.4 on a national basis. However, even though home prices are currently vastly overvalued, the housing market is not in a classic bubble because the real estate market is not currently in the conditions of being over owned or over supplied.
