The rapid recovery in home prices in a number of U.S. metros has already led some observers to suggest that we are in another home price bubble. We find this unsupporting for a number of reasons, the foremost of which is that most people using this term may not fully understand what defines a bubble. We started writing about home price bubbles about 10 years ago when there was a bubble building in a number of important housing markets around the country.
One common theme used to describe bubbles in other markets is the idea that prices have risen very quickly to levels which could not be justified by underlying fundamentals. There are a number of well documented historical examples of bubbles that include the stock market in 1929, gold prices in 1979-80, and Japanese real estate prices in 1989-90. It is typically acknowledged that in the late stages of a bubble, prices keep rising primarily because they are expected to keep rising. At the time of our previous research, we suggested several definitions of home price bubbles based on the concept that home prices had risen far above levels which could be justified by any economic measure. These included the ratios of home prices to household incomes, rents, construction costs, and employment.
While these can be useful metrics in identifying when prices may be overvalued, bubbles typically move far beyond so-called “overvalued levels” and can last far longer than most people expect. The study of bubbles in other markets such as the ones mentioned above led us to develop a straightforward and easily understood “bubble indicator” which works in most markets and does not depend on a deep understanding of the underlying fundamental factors.
Our finding was that a simple measure of how much the market has increased over a five-year period has proven to be an excellent indicator of most bubbles. In the case of the U.S. stock market over the past 100 years, we found that whenever the 5-year rate of change of the S&P 500 Index has exceeded 200 percent, a significant market top has subsequently occurred. Figure 1 above shows the Dow Jones Industrial Index along with this indicator and, as seen, it identified the bubble peaks of 1929, 1987, and 1999-2000. These were followed by the overall stock market “crashes” of 1929, 1987, and the crash of technology stocks in 2000, respectively.
