Canada's Housing Bubble

Aug 3, 2011 Ben Rabidoux theeconomicanalyst.com

Canadian home prices have experienced a decade of unprecedented gains.

The incredible rise in home prices has created a legion of millionaires in Canada.  A recent study by the Deloitte Center for Financial Services estimated that one out of every 65 households in Canada has assets in excess of $5 million.  But the relentless rise in real estate values has also caused some to speculate that the Canadian housing market may be overvalued.  Some have even gone so far as to describe current house prices as a bubble.  I would be among that group.

The funny thing about bubbles, is that some people see them and others do not. Some economists claim that it is impossible to see a bubble until it is gone. There is no question that the most difficult bubble to see, is the one you are within.

Highly respected Wall Street guru Jeremy Grantham, in a recent quarterly letter to his clients, illustrates this point with the story of Isaac Newton, British astronomer, physicist, mathematician and investor of the South Sea Company.  The South Sea Company represented one of the greatest stock market bubbles in history:

Newton had the great good luck to get into the South Sea Bubble early. He made a really decent investment and a very quick killing, which mattered to him. It was enough to count. He then got out, and suffered the most painful experience that can happen in investing: he watched all of his friends getting disgustingly rich. He lost his cool and got back in, but to make up for lost time, he got back in with a whole lot more (some of it borrowed), nicely caught the decline, and was totally wiped out. And he is reported to have said something like, “I can calculate the movement of heavenly bodies but not the madness of men.”

This story gives us great insight into the psychological factors involved in bubble formation.  They are driven by greed and envy on the way up and fear on the way down.  Newton was an exceptionally intelligent person who had amassed a significant fortune, yet he was susceptible to the same human frailties that afflict us all.  We are all tempted by group-think and herd mentality. We take great comfort in being part of a crowd.

Newton’s mistake also illustrates that at some point in the bubble cycle, rising prices become the justification for rising prices.  Demand cannot be met quickly enough, leading to a price increase - which encourages others to jump in as they see the gains made by friends - and demand and price increase further. The continuous rise of demand and price is not supported by any measure of fundamentals, but by simple herd mentality.

So how does a bubble begin? Grantham writes:

… asset bubbles don’t spring out of the ground entirely randomly. They usually get started based on something real – something new and exciting or impressive, like unusually strong sales, GDP, or profits, which allow the imagination to take flight. Then, when the market is off and running, momentum and double counting (among other factors) allow for an upward spiral far above that justified by the fundamentals.  There is only one other requirement for a bubble to form, and that is a generous supply of money. When you have these two factors – a strong, ideally nearly perfect economy and generous money – you are nearly certain to have a bubble form.

The easiest way to think of an asset bubble is as follows:  An asset bubble exists when the prices of assets are over-inflated relative to historic norms, as measured by widely accepted fundamentals.

Bubbles are produced at the intersection of mass psychology and financial innovation. They occur when people flock to a particular asset class en masse, thereby creating excess demand.  While academics and economists often disagree on a precise definition, there are nevertheless several key conditions that are generally accepted as indicative of a bubble.  In this post, we’ll examine the first two.  Tomorrow, the remaining ingredients...

Bubble Condition 1:  A bubble involves a rapid increase in the price of an asset.

Consider a stock has that been rising at a rate of approximately five per cent over the past 20 years.  If this stock suddenly gains 20 per cent each year over the next five years, it would certainly raise eyebrows.

However, a sudden rise in price alone is not enough to determine the presence of a bubble, and this is where most housing observers make a major mistake. It is essential that we examine the fundamentals supporting the asset price in relation to the prices themselves.

In the case of stocks, the most fundamental valuation metric is the price-to-earnings ratio, which is a simple calculation of the price of a stock divided by the amount of earnings it makes per share. For example, a stock that sells for $45 per share and makes $3 of earnings per share would therefore have a price-to-earnings ratio of 15 (45/3).

If the earnings of the stock in our example were also rising by 20 per cent per year, then the price might be justified and fears of a bubble would likely be overblown.   Therefore, it is not the nominal or percentage rise in an asset that is the strongest indicator of a bubble, but rather the deviation in the asset from its measures of fundamental value...

Bubble Condition 2:  The rise in price significantly outpaces the factors upon which the asset price was historically based.

In the late 1990s, the world was captivated by the immense potential of the internet. Starry-eyed investors bid the price of new internet and technology companies to astronomical valuations.  The price-to-earnings ratio of the S&P 500 (an index made up of the stocks of the 500 largest publicly-traded companies) rose to 45, nearly triple its long-term average.

When this bubble finally burst, many of these darling ‘dot-com’ and tech stocks went bankrupt.  The S&P 500 lost over 40 per cent of its value in the following three years, while the tech-heavy NASDAQ exchange lost 80 per cent.

By examining measures of fundamental value and recognizing that prices were not based on historically sound factors, some astute investors, most notably Warren Buffet, managed to avoid the pitfalls of the dot-com bubble.

This same reliance on measurable fundamentals also led some economists to correctly call the US housing bubble.  We’ve spent an extensive amount of time analyzing the various traditional drivers of house prices.  The truth is this:  any asset that outpaces these immutable measures of value should be looked at with a high degree of caution.  Real estate is no different.

More to come...

Ben