Sunday, June 5, 2011

Housing Bubble

I can't recommend NPR's Planet Money podcast enough. I was a little disappointed, though, in their final entry in their series on gold and the meaning of money.  In it they have economists making claims that bubbles shouldn't happen according to economic theory, and yet there they are. To me this looks like gambling, which economists have explained by accounting for the value the gambler places on his enjoyment of the activity itself and his typically inaccurate perceptions of the risks involved, among other more complicated explanations.  For the housing bubble, before the bubble became apparent it would be reasonable for an investor to assume that the asset price was inflating at a higher than normal rate for some unknown temporary period.  At some point, though, the bubble became apparent and then gambling ensued. 

According to Google Trends, the term "housing bubble" in the US first exceeded its Jan-2004 through May-2011 average traffic in Q3 2004.  By Q3 2005, traffic on the term "housing bubble" was 2.85 times the average - the peak.  My interpretation of this is that everybody found out that there was a housing bubble, or at least that there was the possibility of a housing bubble, between Q3 2004 and Q3 2005.  But according to the Composite US S&P/Case-Shiller Home Price Index, housing prices didn't peak until Q2 2006.  If a gambling man purchased real estate when the "housing bubble" buzz first peaked up higher than average on Google in Q3 2004, and then sold at the peak in Q2 2006 he would have been ahead 19.8%.  Even if he waited until Q3 2006, the first time the Case-Shiller actually declined after Q3 2004, he would still be up 18.7%.  The only risk being taken here is that the quarter in which the real estate is purchased might actually be the peak, plus the transaction costs (which are not trivial in the case of real estate). 

But in the face of a possible 18%-20% upside, its not hard for me to see why gamblers were rolling the dice even though they knew there was a bubble.