Wednesday, April 22, 2009

Have we hit bottom? Anatomy of a Bubble

(click on image to enlarge)

Anatomy of a bubble was posted on Charles Hugh Smith's blog and is very interesting so I have condensed and reposted it here. There are more graphs on his site if you are interested.

The big real estate debate in Vancouver right now is, "have we hit bottom? Is now the time to buy?"

Interestingly, no one refutes the fact that we have been in a housing bubble anymore. What people now deny is the fact it is going to continue to burst in spectacular fashion.

And so, with that in mind...

Anatomy of a Bubble

No model can predict the timing, highs or lows of any bubble, but all bubbles - be they real estate, stock market or whatever - tend to follow a pattern traced in human psychology:

1. As euphoria grabs hold, prices rise in a steep ascent to a point at which "everyone" believes there is no end to the trend.

2. The initial descent from the bubble peak is a "shock" which leaves the bubble mentality intact, i.e. the Bull Market in tulip bulbs, real estate, tech stocks, etc. is only suffering a standard retracement/indigestion; the trend higher is still in place.

[which is where we are in Vancouver right now. People are arguing that prices are only suffering a retracement and the upswing in prices will return shortly]

3. In housing, this psychology is embedded in such chestnuts as "they're not making any more land," "real estate always rises over time," "population growth means demand for housing will always rise," "the house is the foundation of middle class wealth appreciation," and so on.

4. At some point speculators who were left out of the initial explosive rise jump in because "prices are a real bargain now."

5. This buying pushes demand above supply briefly, and prices start rising again.

[which is what we are seeing in Vancouver with historic low interest rates and a decline, after 11 months, of over $121,000 in the benchmark price for SFHs]

6. But the realities beneath price action have changed, and this bargain-hunting burst soon fades as demand falters, supply rises and prices renew their descent.

7. Speculators and investors' memory of the tremendous profits made on the way up remain firmly embedded, forming an "investment memory" which locks them into the view that the upward trend will resume at some point. This drives wave after wave of bottom fishing in which speculators buy into an apparent bottom only to be disappointed and see that false bottom wiped out by a renewal of the downtrend.

8. At some point, all the bottom fishers have expended their capital and prices retrace to the pre-bubble levels, or even lower. This is what can be called "the real bottom."

[which in Vancouver Real Estate will probably be pre-2002 ($375,000), down from last years high of approx $910,000]

9. But the memory of past glories still remains in the minds of speculators/investors, and so a subdued uptrend starts as "hope springs eternal" buying kicks in.

10. Eventually this institutional/cultural "memory of an uptrend" fades as the "recovery" in prices fails. The truisms which fed the brief bubble and long post-bubble decline and recovery--that tech stocks were the future, real estate only goes up, the South Seas is the epic investment of all time, etc. are repudiated and lose favor. This is the ultimate bottom.

Can a 10-year bubble reach this "ultimate bottom" in a mere 11 months? History suggests not.

Vancouver's real estate market still has a long way to decline, years not months, with many minor bounces upward along the way.

Remember... it has only been 11 months since the market started to decline. In the United States it has been over four years. This bubble pattern has played out in every American city and Vancouver's drop in the first 11 months outpaces all but 2 or 3 US cities in their first year of collapse.

More importantly the economy has shifted dramatically. Add in the following financial factors that control real estate valuations and you cannot help but conclude the price declines will resume. These factors include:

1. Extreme bubble valuations must eventually retrace to the starting point, and in many cases they drop below the starting point.

Vancouver's real estate bubble started to inflate just prior to 2002. The benchmark price at that time was approx $375,000. We have come nowhere close to retracing to the starting point yet.

2. Housing and real estate are based on the availability of cheap, plentiful debt. As economy-wide debt loads are at historic extremes, it is prudent to ask what conditions will enable trillions more in debt to be issued to buy inflated housing.

3. As the Federal government borrows billions of dollars (in the USA, trillions of dollars) on the open market to fund its mega-stimulus-bailout debts, then the government is competing with private borrowers for a dwindling pool of capital/savings. That will drive up rates, making mortgages more expensive. And since prices drop as rates rise, this global push on interest rates is a profound headwind for housing prices globally.

4. Paying a mortgage requires steady income, which for most citizens means a steady job. Rapidly rising unemployment reduces the pool of potential buyers and adds to the inventory as those losing their incomes also lose their homes. (And BC is leading the nation in job losses with greater losses a certainty).

In short: with the national and household balance sheets at historic extremes of indebtedness it is difficult to see what fundamental financial foundation exists for higher housing prices.

The only conclusion to be drawn is that those currently buying "at bargain prices" will very likely be disappointed as prices renew their downtrend in the near future.

And Vancouver's bubble still has a long, significant ways to go in its downward deflation.



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