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	The Bubble Mentality   (February 22, 2006) By any measure objective, it's long been official: we're in a housing bubble. Here's yet more evidence. This little chart compares housing to the tech stock bubble of 2000 as a percentage of GDP. (For more measures of the bubble, scroll down to the links on the left listed under "Housing Bubble Watch." Also, scroll down to the entries dated February 4, 9 and 18.) Quite understandably, the real estate and housing industries are busy unearthing all the reasons why the bubble is sustainable, and indeed, not a bubble at all; but this stubborn, even desperate confidence eerily recalls the dot-com pundits' certainty that "this time it's different" and the tech boom was more or less eternal. Alas, the Nasdaq fell from 5,000 to 1,100--a drastic decline no one predicted. The psychology of a bubble is peculiarly selective. If anyone had predicted Nasdaq would climb from 1,000 in 1995 to 2,000 in 2000, everyone would have been delighted with that doubling. Yet by the time it quintupled to 5,000, then everyone took the extraordinary rise as inevitable and even rational. Now we find the same psychology at work in housing. If someone had predicted that a $200,000 house in 1995 (the median home price in the S.F. Bay Area at that time) would rise in value to $300,000 in 2005, the buyer would have been ecstatic with this 50% gain. Yet now that the house has tripled to $600,000, the owner feels entitled to that fantastic rise, and fully expects continued gains--just like the buyer of tech stocks felt in late 1999 as Nasdaq seemed to be on a permanent tear upward. And just as no one predicted a massive decline in the Nasdaq in 2000, no one is predicting a crash in real estate values. Yet history has shown that bubbles pop, some violently and some slowly, but none stay aloft forever. The standard line in the real estate industry is that housing will "cool off" and "only" go up by "single digits" per year for a few years to "digest the gains." This sounds like it was copied and pasted from stock market gurus' predictions in 2000. If history is any guide, bubbles--be they of tulips, tech stocks or houses--tend to re-trace all the way back to their value before the bubble. Could $600,000 houses fall back to being worth $200,000? This seems incomprehensible to the average home buyer, because like stock investors in 90s, they've only known a world of ever-rising real estate values. But we're about to enter the world on the other side of the mirror, one in which housing values only drop. How could this be? It's very easy. Just look to an oversupply of product (housing), an exhaustion of demand (all the foolish people have already bought at the top), and then a rise in the cost of money. If mortgage rates rise to 9% from 4.5%, then guess what? Buyers can only afford a house of half the value. With a 4.5% mortgage, they can afford the $500,000 mortgage payment. But at 9%, they can only afford to borrow $250,000. By the laws of supply and demand, the price of housing must also eventually fall in half. Don't think it could happen? Please re-wind your mental tape to the Spring of 2000, and re-read all the predictions of permanent boom and permanent bubble valuations. * * * copyright © 2006 Charles Hugh Smith. All rights reserved in all media. I would be honored if you linked this wEssay to your site, or printed a copy for your own use. * * *
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