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The Five Stages of a Housing Bubble   (March 29, 2006)

March 29, 2006

Psychologist Elizabeth Kubler-Ross suggested the process of grieving has five distinct stages. In a somewhat analogous fashion, participants in the housing bubble will pass through five emotional stages: euphoria, doubt, denial, disillusion, realism.

Kubler-Ross's five stages were: denial, anger, bargaining, depression, and acceptance. As people grieve the losses of their paper profits, or more tragically, the loss of their homes or entire equity, they may well pass through these very human feelings along the way.

My list is somewhat different, as it starts with the essential emotional building-block of any bubble: euphoria. This is the sense of empowering glee as prices rise, seemingly inexorably, as the participants re-calculate their ever-rising wealth--and all without any application of labor! (Or recently, any deployment of capital, either.)

This stage can be seen in the chart of KB Homes, a company which is a good proxy for the large residential builders. The euphoria is visible in the sharp rise of the stock price from mid-2004 to mid-2005.

The decline (which I marked for emphasis) from this peak is the doubt/denial stages. As doubt about the housing bubble grows, the stock price falls. Then, as denial kicks in, the price recovers--but importantly, never to the previous high. This "lower highs, lower lows" is the classic stock market definition of a downtrend.

A similar battle between doubt and denial plays out in the media every month when housing prices, inventory and sales figures are released. Every lower number spurs doubt, and every stabilizing number elicits denial: everything is OK, prices are stabilizing, etc.

At some tipping point, denial gives way to full-blown disillusion. As declines in prices and sales and fast-rising inventories become inescapable trends, the flimsy walls of denial participants have constructed give way, and they become disillusioned with their real estate investments. Some decide to hang on, others decide to bail, and still more stop looking at the very real estate section they used to open first, when their net worth was rising by the month.

As the declines continue unabated, year after year, participants finally make a realistic appraisal of the situation: housing was a bubble, and the deflation seemingly lasts forever. Investors give up and sell in disgust, banks give up the ghost and go bankrupt or sell their portfolios of non-performing mortgages for pennies on the dollar, and the ranks of working realtors thins to those few with connections to lenders, who are still dumping their foreclosed properties.

When nobody in their right mind would consider buying real estate as an investment, the bottom will finally be reached. Unfortunately, all this takes a long time. That we are just in the very first stages of the decline are apparent in articles such as this one from The Wall Street Journal: Back To Reality, about the quickening slide in vacation home values.

So who is still buying houses? It's hard to quantify, but here are my guesses:
  • The true believers: those who really truly believe that "this time it's different," that population growth, restrictive land use and other macro-trends guarantee rising house prices for the long-term.
  • Last year's sellers: many of the folks who sold at the top late last year still want to buy a house to live in. Given their enormous gains, they're not too picky about price declines. They are missing one important piece of the equation, of course--the fact that the property taxes on their new $600,000 house iare a lot higher, permanently higher, than they were on the house they bought for $100,000 and sold for $600,000.
  • The wealthy. Some people have so much dough they really don't care if the value of their condo in Florida or Hawaii falls in half. They like it and don't plan on selling it. The number of people in this category who will be buying, however, is sure to shrink rapidly as prices drop. If prices are falling, why not wait and buy cheaper tomorrow?
  • Die-hard real estate investors. As Corrie Anders, my old editor from the S.F. Examiner Real Estate section noted in the S.F. Chronicle Sunday Real Estate section's lead article, investors are simply moving farther afield in their search for "cheap" properties: North Carolina, Arkansas, etc. GREENER PASTURES: Frustrated by high housing costs, Bay Area investors are sending their real estate dollars out of state.

    What appears to be lost on these folks--many of whom own six, ten or even more houses scattered around the country--is that they're simply exporting the bubble to areas which didn't have bubbles for a very good reason: permanent residents lack the big-bucks incomes needed to overpay for houses. While a house valued at $169,000 seems cheap to a Left or Right-Coast investor, when that house drops back to $80,000 in a few years, the loss suffered will be, percentage-wise, as unpalatable as losses suffered in "hot" areas. For examples of locales which are clearly toppy, skim this chart:

    Among the nation's most overvalued markets are these metro areas with a high concentration of vacation homes, where prices are pushed up by out-of-town buyers. Source: WSJ
    Naples, Fla. $367,100 96.3%
    Santa Barbara, Calif. 638,000 76.7
    Bend, Ore. 256,200 68.4
    West Palm Beach, Fla. 274,300 59.0
    Ocean City, N.J. 304,500 49.5
    Barnstable, Mass. 352,800 45.8
    St. George, Utah 225,400 42.9
    Phoenix 233,500 41.9
    Las Vegas 273,200 39.0
    Honolulu 554,600 35.3
    Note: Median prices are as of fourth quarter 2005. Overvaluations are based on historical norms for home prices, household income, population density and other factors.
    Source: Global Insights/National City Corp. survey of 299 metro markets


    copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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