Open Reply to Rusty – “Just because you perceive a bubble does not make it so. Bubbles are only identified after they’ve burst.”

Rusty at VREAA 30 April 2011 8:47am –
“vreaa,
Just because you perceive a bubble does not make it so.
Bubbles are only identified after they’ve burst.
Or do you define a bubble as a real estate market where you personally cannot afford to buy?
What is your “pre burst” definition?”

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Dear Rusty

Thanks for your question.

It is a myth that “Bubbles are only identified after they’ve burst”. The myth is propagated by those directly or indirectly benefiting from the bubble, and also by vested interests in postions of responsibility, who could make a difference, but decline from so doing. An example of this is Alan Greenspan keeping monetary policy too loose through the tech and US housing bubbles, claiming that you can’t identify a bubble in advance. Greenspan is simply wrong on this point, and many observers saw those bubbles for what they were during the process of them being inflated. Yet, we still hear this myth perpetuated (as in your bold claim). This is closely related to the ‘hoocoodanode’ responses you’ll get from various players after a bubble inevitably bursts. It’s also a way of those guilty of policies and actions that perpetuate bubbles to claim innocence after the fact.

A speculative bubble can most definitely be identified while it is inflating. Such a bubble occurs when prices of any asset lose contact with fundamental values of the asset and start rising higher and higher simply because they are rising higher and higher. All buyers in such a market buy with the expectation of higher prices, some buying solely for the expected higher prices.
Almost all bubbles are supported by fallacious arguments citing ‘reasons’ for differences between bubble price and fundamental value. For instance, during the tech bubble, we heard the argument that P/Es of 1000 were merited because “we’ll be able to sell to everybody” (neglecting to take into account the fact that everybody else will be able to sell to everybody, too).
Bubbles are also facilitated by large quantities of easily available cheap capital.
They are all versions of Ponzi schemes, where, essentially, the late-comers are left holding the bag after prices collapse, and the only players who profit are those who get out early enough (surprisingly few), and those who sell ‘shovels to the prospectors’ (brokers; some developers, some in construction, etc).
All bubbles deflate, no exception (If you can think of any, let us know). Prices return to levels that make sense according to fundamentals. In fact, as we see now happening already in some areas of the US housing market, they often drop well below fundamental value, and may remain depressed for the better part of a generation. Bubbles are very, very destructive to a community, both through the terrible misallocation of human effort & resources on the way up, and through the tragic financial, social, and psychological consequences of the aftermath.

In Vancouver currently, median housing prices are about ten times median income, and rental yields are extremely low, much lower than one would expect even at current low interest rates. Thus, prices are far, far removed from those merited by fundamental value. By our calculations, prices are 2 or 3 times fair value, meaning that we’d expect price drops of well over 50% when the bubble deflates. But people continue to buy believing that prices are only going to go up (or, a slightly different version, that prices couldn’t possibly drop by more than 5% or 10%, before continuing higher). Higher and higher prices are ‘supported’ by fallacious arguments (“we’re running out of land/best place on earth/never-ending demand/foreign buyers”). Capital is very freely available, along with low deposits, long amortization periods, and government loan insurance.
By all measures, we are in a massive speculative bubble. Massive in terms of both the percentage of citizens involved, and the size of the overvaluations. This is not an opinion, it is a fact.

You have suggested that we may define ‘bubble’ as a market in which we, vreaa, cannot afford to buy. That is a fair thought for you to have. We could claim that this information it is neither here nor there to this discussion, but it is fair for you to know if we’re just ‘talking our book’. So, we’ll share with you that we can indeed ‘afford’ to buy, even at current prices, and definitely by all Vancouver standards. But we choose not to, because of the massive disconnect between price and fundamental value; because of the RE bubble. There is a very small minority of prospective buyers in this position in Vancouver. It is never easy to be on the wrong side of a bubble, but what else can you do but call it as you see it?

Say we had to reframe your statement to read: “Bubbles are only identified by the vast majority after they’ve burst.”
That we’d agree with. By definition, once even a minority start bailing, the bubble bursts. We haven’t reached this point yet in Vancouver’s remarkable market, but we will get there, and after we do, there will be a very broad consensus that we have indeed been through a very large bubble.

regards,
vreaa