The real estate bubble that started at the turn of the millennium was the greatest we’ve seen in the past 120 years. As the saying goes, “the bigger they are, the harder they fall” and this is why we’re still seeing the effects today. In hindsight we can shed some perspective on this last bubble and see just how big it was in relation to previous bubbles of the last century.
The Making of a Bubble
As soon as prices start to rise in any economic cycle, someone is bound to start crying “bubble” and the Chicken Littles come out to tell us “the sky is falling”. How do we know when they’re actually right about a bubble?
The following is a graph of the Case-Shiller Index of American Home prices indexed back to 1890 and will give us some ideas about what can be considered a bubble. (Click the image to see full-sized)
Looking at the graph we can see the magnitude of the bubble that formed between 2000 and 2008 was far greater than anything we’ve seen in the past century. In the early half of the 1900s, the First World War, Great Depression and Second World War depressed values for an extended period which was followed by a quick return to more normal values following the war. Home values then remained relatively stable until the booms of the ’70s and ’80s which ended before they got too out of hand. Following the dot-com crash of early 2000s, a significant run up in house prices fueled by low interest rates and loose lending criteria led to overly inflated home prices. When the credit crunch hit, the house of cards started to collapse and created what is now known as the “Great Recession”.
Look for Sustainability
When looking at home prices and trying to determine whether a bubble exists, it is important to put things into perspective by considering things like the graph above. Looking at indexes can help us understand where values stand today in relation to the past. Whether we are looking at home prices, interest rates, or affordability we want to see what the trends are and whether they are sustainable. Most people would agree that the growth in house prices seen in the early 2000s were not sustainable, but during the boom people let emotions take hold and the collective “Irrational Exuberance” led to one of the largest housing bubbles we’ve seen to date.
Never let your emotions control your investing choices. Take the extra time to examine the trends, put things in perspective, and make an educated decision.