When thy neighbour’s house doth burn, then look to your own. What should we expect? Part 2

In part 1, we looked at how the factors that contributed to the ‘boom’ in prices have changed, now let’s look at what has happened in other cities that have undergone a similar increase in prices, which ultimately corrected and hence were defined as a bubble. Do we know if we are in a bubble?

Asset Bubbles

An asset bubble occurs when the price of a financial asset or commodity rises to levels that are well above either historical norms or its intrinsic value, or both. There are countless examples of asset bubbles from the past. Unfortunately, the problem is that bubbles are only obvious in hindsight, but are very difficult to spot when one is in the middle of it, and that is because people build stories, suspend their belief in traditional metrics and tend to ignore any contrary views. Bubbles are basically positive feedback loops similar to those found in ponzi schemes and they can last a very long time. Many people who are skeptical at first, eventually succumb to the pressure and abandon their disbelief and join the euphoria around a particular popular asset. Hence, all what we can do is to look at past asset bubbles and look for common characteristics of them. Ray Dalio has done that and has come up 7 characteristics that have defined bubbles from the past:

  1. Prices are high relative to traditional measures
  2. Prices are discounting future rapid price appreciation from these high levels
  3. There is broad bullish sentiment
  4. Purchases are being financed by high leverage
  5. Buyers have made exceptionally extended forward purchases (e.g., built inventory, contracted for supplies, etc.) to speculate or to protect themselves against future price gains
  6. New buyers (i.e., those who weren’t previously in the market) have entered the market
  7. Stimulative monetary policy threatens to inflate the bubble even more (and tight policy to cause its popping)

This is how recent asset bubbles have satisfied these criteria:

Now let’s go into each of these criteria and apply it to Vancouver Real Estate:

QuestionVancouver status (2015-2018)
Are prices high relative to traditional measures?
Yes, we showed in a previous blog entry that Vancouver defies a number of traditional metrics. Price to income is the highest it has ever been. Price to rent is off the charts, and prices have deviated from the long inflation corrected trend.
Are prices discounting future rapid price appreciation?
Yes. Reports such as this one from Vancity in 2015 was again predicting an increase in prices all the way to 2030. The increasing trend in prices attracted more investors who anticipated that prices would continue to go up, as we discussed in our previous post.
Are purchases being financed by high leverage? Yes, the debt to disposable income is at an all time high as we discussed in the last blog entry. It is at the same level as it was in the US prior to the Great Financial Crisis
Are buyers/companies making forward purchases? Yes, people used to line up for days for pre-sales of condos. As we also discussed in a previous blog post, people would flip properties even before they received the property.
Have new participants entered the market?
Yes, we also discussed that the credit boom in China brought a lot of investors into the Lower Mainland.
Is there broad bullish sentiment? Yes, just look at a few samples of the Vancouversun headlines in the 2015-2016 period:
B.C. economist says price of Metro Vancouver houses will keep climbing (Dec 2016)
Vancouver’s ‘housing bubble’ shows no signs of bursting (Sep 2015)
Metro Vancouver home sales continue to soar in summer (Sep 2015)
Does tightening risk popping the bubble?Yes, a recent survey indicated that 46% of Canadians are at the brink of insolvency.

It is difficult to conclude that we are not actually experiencing a bubble.

Other real estate bubbles

Perhaps the best remembered real estate bubble is that of the US from 2004-2007, which resulted in a significant correction that ultimately precipitated the Great Financial crisis of 2008. The following chart shows how the house prices in 10 top cities in the US changed during this period (source):

As can be seen in the chart, the ‘boom’ took place rapidly in the 2004-2006 period. Prices remained ‘flat’ for ~1.5 years (some people thought it was the ‘soft landing’), and then prices corrected from the peak in April 2007 to the trough in March 2009. It took 2 years (source).

Compare that with the .com correction in the stock market, which went from peak in August 2000 to trough in March 2001 (6-7 months, source):

Real estate corrections tend to be slow, and last many years (see more on that below).

Let’s now see a case study for which we have actual real estate data to see what stats tell us during a real estate bubble.

Example: Phoenix Arizona

I looked for real estate stats for cities in the US. I found nice data for Phoenix. A nice interactive graph of the 2004-2007 bubble in Phoenix, Arizona helps us understand the sequence of events in a real estate bubble (click here to get to the interactive graph, source):

As you can see, in the 2000-2003 phase, prices were steady, and inventory (Homes Listed for Sale, red graph) was about 4-5 times bigger than sales (Homes Sold, blue line). The Sales to Active Listing Ratio was ~0.2-0.25. Then the euphoria phase of 2004-2006 came and inventory plummeted as sales picked up. At one point (around January 2005) the sales were greater than the total inventory (SAL>1.0), indicating that houses were selling like pancakes. A house hit the market and it sold almost immediately. This is the euphoria phase. Prices (green line) escalated rapidly here. At the end of the euphoria phase in 2006 sales plummeted (going from ~9000 in the summer of 2005 to ~3000 in the fall of 2007. Inventory escalated rapidly, and the SAL plummeted to around 0.10 around May 2007. Prices remained steady from August 2005 to the summer of 2007. Then prices started correcting, reverting to the 2000-2003 baseline over the course of 2 years, from summer 2007 to summer 2009.

If we plot the same graph for detached homes in Vancouver using the numbers from Saretsky’s website, we can see that similar to Arizona, there was a significant drop in inventory and spike in sales in the 2015-2016 period, and prices remained steady for 2 years, and have started their decline:

Disclosure: I retrieved the numbers in October 2018, and have updated manually the numbers from his website since then. In January Saretsky changed his website and the numbers to September 2018 have changed slightly (I don’t know why), but the trends are very similar.

Seattle as a better comparison

Phoenix might not be a good comparison to Vancouver, as it is not in the West Coast, and it is not as land constrained as Vancouver itself. Seattle might be a better point of reference. The Seattle bubble website provides a good look at how the price to income ratio changed in Seattle in the 2004-2006 boom, and how it corrected in the 2007-2012 period:

I could not find sales and listing data for Seattle for this period in a format that could be tabulated or replotted, nevertheless this graph shows that once again inventory dropped in the 2004-2006 period (boom), and then it went up in the 2007-2009 period, and again it is anti-correlated with the inventory (source):

Are bubbles like these common?

Banking crises are fairly common worldwide

If you are young and grew up in Canada, you might not have experienced first-hand a banking crisis like the one in the US. You might also not remember the last big cycle in Vancouver from the early 1980s. (see this nice article summarizing the last time prices went to the roof and corrected, a lot of similarities) You might think that it is a very rare event and that it is unlikely to happen here or in other places. That is inaccurate. Banking crises arise in great part because of credit cycles that are really long lived (Ray Dalio indicates that the long debt cycle is ~80 years long, short ones are in the 10-12 year span). It might take decades for people to experience one, but they have happened before and will happen again, they are a natural consequence of credit cycles as Ray Dalio so eloquently explained in his video.

Reinhard and Rogoff have studied systematically the occurrence of banking crises worldwide in their book, and as their table shows, they happen everywhere, at a rate not too different to what Ray Dalio described, about 1-2 crises per century:

In their book, they also explain that frequently liberalization and capital flows precede a banking crisis. Not surprisingly, banking crises are also often preceded by a boom in real estate prices:

The now-infamous real estate bubble in the United States that began to deflate at the end of 2005 occupies center stage as a culprit in the recent global financial crisis. But the Second Great Contraction is far from unique in that regard. In an earlier work, we documented the trajectory in real housing prices around all the post– World War II banking crises in advanced economies, with particular emphasis on the “Big Five” crises (Spain, 1977; Norway, 1987; Finland and Sweden, 1991; and Japan, 1992). The pattern that emerges is clear: a boom in real housing prices in the run-up to a crisis is followed by a marked decline in the year of the crisis and subsequent years. Bordo and Jeanne, also studying the advanced economies during 1970– 2001, found that banking crises tend to occur either at the peak of a boom in real housing prices or right after the bust

Reinhart, Carmen M.; Rogoff, Kenneth S.. This Time Is Different (Kindle Locations 2629-2637). Princeton University Press. Kindle Edition.

They provide a nice table summarizing some of the recent real estate booms and busts and their corresponding banking crisis:

Cycles of real housing prices and banking crises
Reinhart, Carmen M.; Rogoff, Kenneth S.. This Time Is Different (Kindle Location 2647). Princeton University Press. Kindle Edition.

Interestingly, the magnitudes of the declines in real housing prices around banking crises from peak to trough are not appreciably different in emerging and advanced economies, and they tend to last four to six years.

Summary

We have evaluated the criteria that Ray Dalio has established for debt bubbles and Vancouver Real Estate fulfills all of the criteria. We have looked at what happened in various cities in the US, particularly in Phoenix and Seattle and confirmed that in bubbles inventory tends to drop and sales to rise in the boom phase, and start reverting at the top phase, and finally revert rapidly in the depression (bust) phase. We have then looked at the work of Reinhart and Rogoff from Harvard that show that Real Estate bubbles often accompany a banking crisis, and that they are prevalent worldwide in cycles that tend to be 50-100 years long.

We should not fall into the ‘this time is different syndrome’ and think that Vancouver is different. Based on what we discussed here and in the last post. We should strongly consider that we are experiencing a long term debt cycle that could result in a bank crisis like those seen in the past. When thy neighbour’s house doth burn, then look to your own.

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  1. […] we follow course? Nah, it is different this time, […]

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