Prices Up; Bubble Possible?

While the market is showing signs of slowing, things are different today than during the last downturn. 

By Scott Wright, manager of business analytics

Home prices have had an epic run since 2012, up a staggering 36.1 percent through June 2016, according to the S&P/Case-Shiller U.S. National Home Price Index. This run has been so impressive that home prices are now only within about 1 percent of their 2006 apex, nearly erasing that brutal six-year run that had such devastating effects on the real estate industry and the economy as a whole.

Sellers, investors and real estate sales professionals have all enjoyed this run, but how long will it continue to endure? Is this another bubble that will be subject to a powerful reckoning? Nobody knows what the future will hold, but there are some signs that demand attention.

The Banking Sector

One thing that should ease your mind is the state of the banking sector today compared to 10 years ago. More sub-prime loans (nearly $2 trillion) were originated from 2004 to 2006 than in the previous 10 years combined. Such appallingly low lending standards allowed people, who couldn’t afford them, to secure loans. When home prices declined and adjustable-rate mortgages reset at higher rates, defaults were widespread. A tidal wave of defaults naturally crushed the securities that were backed by these mortgages, which ultimately wreaked havoc on the global economy.

Things Have Radically Improved

Fast forward a decade and, as you know, things have radically improved. The Great Recession has come and gone; investors have regained confidence, and after taking its lumps, the banking industry has instilled smarter lending practices while the investment community has been more cautious in creating instruments that leverage these loans. There is much debate as to the bubble status of the current housing market boom, there is; however, no denying that risk is much lower as it relates to the mortgage market.

Watch the Stock Market

While historically there hasn’t been a super-tight positive correlation between the stock markets and home prices, a more recent trend does indeed warrant some attention. Have a look at this chart that shows the Dow Jones Industrial Average overlain by the S&P/Case-Shiller U.S. National Home Price Index from 2003 to June of this year.

The housing bubble and bull stock market that developed in the early 2000s fed off one another. Everyone felt rich as their primary physical asset and stock portfolios skyrocketed. From its late 2002 low to the 2007 high, the Dow soared a whopping 94 percent over which time home prices increased by nearly 50 percent.

By 2007, home prices and the stock markets were in tailspins that dizzied investors. The Dow went into major correction mode, getting cut in half as home prices continued their precipitous decline. This rough patch coincided with the Great Recession and created gnashing of teeth across all markets.

The Dow finally bottomed in early 2009, giving way to a much-needed recovery. This recovery unfolded at a time when the United States and global economies were still on edge, hence home prices continuing to trend downward as many still didn’t quite trust the turnaround. Stock market investors were the first to trust it as they witnessed a dearth of capital hitting the economy via the Federal Reserve’s aggressive Quantitative Easing (QE) campaigns. QE along with the Fed’s unprecedented Zero Interest Rate Policy (ZIRP) provided a backstop for investors, so, with money falling from the sky, there was no way the economy couldn’t improve, and the stock markets responded.

The gun-shy real estate markets finally responded to the Fed backstop, and beginning in 2012, home prices started to soar. Now, in the summer of 2016, there’s been no letup. Tight inventories, low interest rates and the perception of a strong economy have created the perfect storm for home prices.

It is the perception of a strong economy that is worrisome. Interestingly, greater than two-thirds of U.S. GDP is driven by consumer spending. And, the primary reason consumers are spending is the wealth effect that’s been created by the ongoing stock market bubble. Yep, these record high stock markets are now creeping into bubble territory measured by valuations. The Dow’s unprecedented run with nary a material correction to blink at for years on end has consumers feeling rich.

This is a dangerous position that could end badly, but the Fed is trying everything in its power to prevent a recession from happening. As if their open manipulation of rates isn’t enough, there are now rumblings of NIRP, a negative interest rate policy.

The Fed’s reckless meddling in the economy will eventually backfire. There’s only so much funny money you can pump into the system and only so much that interest rate finagling will accomplish. The Fed backstop will eventually come crashing down, and the stock markets will have their day of reckoning. Investors who have been convinced that the stock markets are as safe as a money market fund will see their dreams dashed in quick fashion.

The bottom line is that a major stock market correction is long overdue. And, possibly, once the stock markets crumble, home prices will turn downward. Recession or not, in declining stock markets people naturally feel less rich, and they won’t spend as much on homes. And if a recession does hit, which is also likely since it’s been over seven years since the last one, it will put even more down-ward pressure on home prices. We’re not doomsayers, but we do believe in market/business cycles. For those of us in the real estate industry, perhaps it would behoove us to pay attention to what’s going on in the stock markets.

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