UCLA Economists Warn of "Housing Bubble"

True, California is the land of fruits and nuts. But the Wall Street Journal is reporting that this particular group of Californians—specifically, a batch of UCLA economists—announced this month that the U.S. and most distinctly California are “beset by a housing ‘bubble’ that will depress construction next year” and will not return to 2004 levels for years to come. Now we all have a healthy skepticism when Phd’s start predicting things, don’t we? And we should. However, this particular group of fruits and nuts has got it right. Why do I say that? The same group was one of the first to predict the 2001 recession. And, once again, history is on their side. Let’s take a walk through history. Some of you who have read my column since I first opened Smartstocks.com in 1998. Suffice it to say that I know something about bubbles—about euphoria and overvaluation of an asset class. First, some common sense observations…very unscientific, but quite meaningful if you have learned the hard lessons of investing history as I have. Then we wrap up with the facts and data and you can email me and tell me if you think these guys are right in saying that U.S. housing returns have peaked and certain areas are wildly overvalued in December 2004. As a stockbroker at Merrill Lynch in 1999 and 2000, I was a member of an army of 15,000 who was trained to shrug off the notion that we were in a bubble. I had more than quadrupled my little portfolio on the internet, as many did. It seemed everybody knew that technology couldn’t go down. Tech IPOs went up 500% their first day on the market. “This is a new economy. Only idiots can’t see how new technology is never going away. It’s different this time.” The most dangerous words in investing are “guaranteed returns” and “It’s different this time.” I bought it, and so did 80 million other Americans who happily leapt into the stock market. Only a handful of major players called it a bubble, in writing, between January 1999 and January 2000, when the NASDAQ almost doubled in one year. Ironically, it was really only those investment advisors tenured long enough to have passed through the energy bubble of the early 1980s or the LA housing bubble of the early 1990s. Between March 2000 and March 2003, I learned a hard lesson. The Nasdaq went from 5100 to just over 1000 in 36 months. Being all of 24 years old with two years of above-market returns gave me enough overconfidence to miss some red flags. Talk about eating crow. I lost most of my life savings. I made lemons out of lemonade, getting an MBA, doing the CFA exams, put on the hindsight-learning goggles, running small businesses, and hitting reset button on my investment philosophy. With the grace of god and the power of options leverage, I am one of the fortunate ones who was able to climb his way back above pre-bubble levels in the last year, even though the Nasdaq could take until 2009 or 2010 just to recover its losses and to regain that notorious 5,000 level. But oh, to have seen the writing on the wall. I think it’s fair to say I know something about bubbles. Red Flag #1: Historically Abnormal Returns. Over the last seven months, I have flown back and forth between the Bay Area in California and my anonymous red state. Somehow, I got stuck next to, behind, in front of, or across from a real estate nut on every single one of those flights. High fives are followed by long stories. Everyone in California has heard the same phrase this year umpteen times in Calfornia, “My friend____ bought a house ____ months ago, and she’s already made ____ thousand dollars.” First, she hasn’t made a penny until she sells it and counts her cash in the bank, net of her 3-6% realtor fees, and taxes. Second, most Americans have refinanced, cashed out, and spent over 50% of their home equity for the first time since World War II. History doesn’t lie…and it gets worse in the hyper-speculative, overbought markets like LA and San Francisco. In the Bay Area of California, local media now reports that over 70% of new loans are adjustable rate mortgages…what happens when all those adjustables ADJUST from 4.0% on average to their historical average floating rate of 7 or 8%? Some Bay Area families are rich enough to pay double their current mortgage payment, but how many of them won’t flinch when their mortgage payment doubles? Remember the crazy uncle who told you to buy Yahoo at $200 in 1999? Where the hell is he now? He’s buying up a slew of plain-vanilla, two bedroom condos like the one I scouted in San Francisco for the bargain price $750,000. I watched the bidders actually fight over the damn thing until the price went up so high, it exceeded the bid price by $30,000. Does any of this sound familiar to you? People fighting to get in a bid on a house and saying things like, “we better move fast, or the price will just go higher next year.” Red Flag #2: Housing costs in Bubble Areas Exceed Wage Differences. “But the wages are higher here…San Francisco is never going away, baby…and besides…I can make the payment.” True, I just bought a nice two bedroom condo near Salt Lake City for $92,000, and priced out a similar one near Denver for $170,000. Do San Fran jobs pay ten times the wage in Salt Lake City or five times? Assume wages are 40% to 50% higher in San Fran vs. Salt Lake or Denver. They are all little starter homes, almost exactly the same. The national average for a two bedroom condo with 1200 square feet is between $100 and $150 per square foot. Yet in Malibu and San Francisco, they are paying $550, $650, $750 per square foot on average and even more in the posh zip codes of California. Bond ratings are boring to most people, but California’s state debt has been down graded by every major firm that rates debt to the lowest rating of any U.S. state. In other words, in the unanimous chorus of the bond market, California’s is the less likely to continuously pay its debts by creating new businesses, jobs and tax revenue than Wyoming, Vermont, or any other state in the country. It’s a new topic for a new day, but California’s soaring debt, punitive taxes, and anti-business wacko regulations have caused businesses to flee at the rate of 500 to 5,000 small businesses per month, depending on whose numbers you read. Who is left to sell these $750,000 condos to in 2005 in San Francisco? 30 year fixed mortgage rates, according to Economy.com should rise from this week’s rate of 5.3% to 6.5% in 2005, then to 7.5% in 2006. Red Flag #3: Investor and Media Euphoria. “It’s a real asset. People are always going to want a nice house in (Vegas, Malibu, San Fran)!” It’s true. Those are posh areas with great weather and night life. Not nice enough, however, to avoid the inevitable laws of supply and demand. The average home in Las Vegas went up 54% in the last twelve months, more than ten times the return on a 10 year U.S. Treasury bond. Those types of returns are simply not sustainable and it is only a matter of time. I don’t know when, but I know how a bubble deflates. It deflates painlessly and slowly during the first year, because the losses are small and not noticeable. Stubborn money even buys more, and passes it off as a buying opportunity. Does that sound familiar? In 2000, for example, a lot of people blamed mild losses on Al Gore and the election recount and ignored calls to sell amidst what we now know was the “gentle beginning” of the bubble’s burst. Imagine if only one of ten prospective homeowners decides to hold off for better rates or better prices or a better job in a market where homebuilders have years’ worth of inventory on sale or already under construction. Can housing prices go down and stay down in pretty areas with great weather? Ask the poor folks who bought a home in Southern California, for instance, in 1990. It took seven years for the average home to simply climb back to its pre-bubble levels. After 3% inflation, buying and selling at the same cost means these millions of homeowners lost over 15% of their mula, while the stock market doubled. To be fair, housing prices are less volatile than stock market indexes. Also, a house has the intrinsic value that a stock doesn’t—you can live in it, as long as you pay the mortgage and property taxes on time. However, housing prices are not as steady as you might think. You just can’t see the volatility because it’s not traded every day on an exchange and announced every night on the news. Long-term U.S. average housing has gone up around 4% to 6% per year since World War II. Take out 3% for average inflation, and a bit for property tax, and you can expect a modest 1 to 3% real return annually. In short, most markets will crawl back to average housing appreciation rates, while hot markets like California will navigate through a bear market that is already staring, then will likely stagnate for a couple years before the interest rates give these areas a painful end to a decline that could last 4 to 6 years in San Fran and LA, in my view. The deflating bubblets in these areas will experience only slow declines for the next 12 months…nothing bad…until that mortgage rate gets high enough to make the average buyer worker say, “no thanks, we’ll just have to wait for now.” Then, probably sometime in 2006 or 2007, 30 year fixed rates will rise above the critical 7% and 7.5% thresholds and 70% of those overbaked adjustables trigger an effective doubling of mortgage payments for millions of homeowners. It has been said that the last year of the bear market is the one that really ravages you. Only when it’s too late, the commentators will note the drop in housing prices and suggest that we all run for the exits…just like they all did at the stock market bottom in early 2003. Unfortunately, many get out right at the bottom, when the pain is maximized. Avoid the hyper-borrowing techniques. I try to keep at least 20 to 25% equity in any property at any time. Thank you for visiting us at Smartstocks.com and enjoying our stock market simulation game over the past six years. Supporting Articles: New Home Sales Plunge 12% in November—Steepest Drop in 10 years http://money.cnn.com/2004/12/23/news/economy/home_sales/index.htm WSJ, 17 December 2004, “Are You Living In A Bubble?”, 8 December 2004, “Sizing Up the Threat of A Housing Bubble.”