A decade ago, a bubble in house prices led to the worst financial crisis since the Great Depression.
House prices then collapsed, falling below their long-term trend.
In recent years, however, as the economy has recovered, so have house prices. And while they are still a long way from their 2005-2007 bubble peak, they’re also now once again far above their long-term average.
There are two common valuation metrics with which to measure house prices: Price-to-income and price-to-rent.
The chart below from Jeremy Grantham of GMO shows price-to-income for the past 40 years.
As you can see, for the last quarter of the 20th Century, price-to-incomes remained in a narrow band. Then they blasted off to bubble land. Now, in an “echo bubble,” they’re climbing well above average again.
The U.S. housing market, although well below 2006 highs, is nonetheless approaching a one and onehalf-sigma level based on its previous history. Given the intensity of the pain we felt so recently, we might expect that such a bubble would be psychologically impossible, but the data in Exhibit 1 speaks for itself. This is a classic echo bubble — i.e., driven partly by the feeling that the substantially higher prices in 2006 (with its three-sigma bubble) somehow justify today’s merely one and one-half-sigma prices. Prices have been rising rapidly recently and at this rate will reach one and three-quarterssigma this summer. Thus, unlikely as it may sound, in 12 to 24 months U.S. house prices — much more dangerous than inflated stock prices in my opinion — might beat the U.S. equity market in the race to cause the next financial crisis.
As the chart above suggests, the price level at any given point in time tells you almost nothing about what prices will do next. But over the long run…
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