We are reading more and more articles asking the question, “Are we in a housing bubble?” Clients have been asking us about this, so we wanted to share our thoughts on the topic.
We will start first with defining what we believe is a housing bubble, then investigate to see if we see evidence to support if we are in such bubble now -- the answer to this question could have a big impact on the economy over the next 24 months.
In this blog, you’ll learn:
- What is the definition of a housing bubble?
- Do we see evidence of a current housing bubble?
- What actions might I take if there is a housing bubble?
- How could a housing bubble impact my portfolio?
Housing Markets Vary by US Region
We should first acknowledge that the residential housing market can vary considerably in different areas in the US. Some regions of the country have had prices increase more than others, and some areas could have prices fall more than others. Living in Silicon Valley in California, we see prices going up and down more than many regions.
For the purposes of this conversation, we are going to look at the US, understanding that the individual housing markets will vary in different parts of the country. We will look at data provided by the US Federal Reserve Bank of St. Louis.
What is the Definition of a Housing Bubble?
To determine if we are in a housing bubble, we must first define and understand the definition.
We think a bubble in the US residential housing market consists of these 4 elements:
- Significant increase in the prices of residential homes
- Introduction of a catalyst that could cause the increase in home prices
- Removal of a catalyst that could cause residential home prices to fall
- Potential for a significant drop in the price of residential homes
Let us now examine each of these elements to understand what the data suggests.
Explore for Evidence of 4 Housing Bubble Elements
1. Has there been a significant increase in the price of US residential homes?
Economists generally agree that there was a housing bubble in the US in 2005 to 2007. If we look at the graph below, housing prices are more extended to the upside now than they were in 2006.
Chart 1.Median Sales Price of Houses Sold for the US1
We live in Silicon Valley in Northern California and in our neighborhood several very modest 3-bedroom and 4-bedroom homes are going on the market at $2.4M to $2.5M and selling for $700,000 over asking price, with many offers.
As we talk with our clients, housing markets around the country have seen a large increase in home prices. The data in the graph above supports that there has been a recent significant increase in housing prices extending above the longer-term trend line more than any time since 1965.
✅ Conclusion: Yes, to the first element to determine if we are in a housing bubble as we have seen a significant increase in US residential home prices.
2. Has there been a significant increase in the price of US residential homes?
When the Federal Reserve changes interest rates, that tends to cause the 30-year home mortgage rates to move in the same direction.
Chart 2. Federal Funds Effective Rate2
When the COVID pandemic hit in March 2020, the US Federal Reserve reduced interest rates for the Effective Rate to near zero. The 30-year mortgage rates reached a bottom in early 2021, at about 2.75%, which is an extremely low rate, and the lowest rate in over 50 years.
Chart 3. 30-Year Fixed Rate Mortgage Average in the United States3
When interest rates are this low, it allows new home buyers to spend more on their house for the same monthly payment. We believe this extremely low 30-year mortgage rate is a significant catalyst for the increase in housing prices.
✅ Conclusion: Yes, to the second element of the definition of a housing bubble, that there was a catalyst to cause a significant increase in housing prices.
3. Will there be a removal of a catalyst that could cause housing prices to fall?
The Fed Funds Effective Rate, in Chart 2, shows that the Federal Reserve has raised the Fed Funds Rate from zero to 0.25% in March 2022.
According to the CME FedWatch Tool4, the highest probability is for a 0.5% rate hike in May, 0.5%-0.75 rate hike in June, and another 0.5% rate hike in July. They predict the Fed Funds rate could be 2.75% by December 2022, which would be one of the fastest rate hike cycles by the Federal Reserve in the past 100 years.
In anticipation of this rate increase, the 30-year mortgage rates have risen sharply, going from about 3% in January 2022, to about 5% in April, and we think rates will go up more before the end of 2022.
This would be a major change in mortgage rates, which would reduce the size of the loan that a prospective buyer could get for a specific monthly payment, and thus reduce the value of a home they could purchase.
✅ Conclusion: Yes, to the third element or indication of a housing bubble, that the catalyst to cause a significant increase in housing prices will be removed and new buyers will be able to buy a significantly lower priced home over the next few years.
4. Is there potential for a significant drop in the price of residential homes in the US?
We can see in Chart 1 that housing prices have risen significantly above the long-term trend line for the growth in home prices.
If we take a closer look at Median Sales Price history, the trend line for the growth puts the price of homes at about $275K for April 2022; however, the chart shows the median price is significantly higher at $408K.
Chart 1-Annotated. Median Sales Price of Houses Sold for the US1
In 2009 and 2011, the housing market corrected 19% back to the long-term trend line. A correction down to the long-term trend line in 2022, could result in a 33% drop in housing prices -- this would be a significant drop in residential housing prices. Some might say that, “this time is different,” but we are always skeptical of this phrase.
✅ Conclusion: Yes, to the fourth element given the history of the past 50 years shows that there is the potential for a significant drop in the residential housing prices in the US.
Is the US residential housing market in a bubble?
We have discussed each of the 4 criteria to determine if the US residential housing market is in a bubble. We have found supporting evidence to say that all 4 elements are present. In conclusion, yes, we believe the US residential housing market is in a bubble.
We believe that there will be a significant correction and downward movement of housing prices. If we look at home prices from the last housing correction, the peak was in Q1 2007, and the bottom was in Q1 2009. It took 2 years for the correction to be completed and a similar 2-year duration could be expected for this current cycle, before housing prices correct to the long-term trend line.
The gray bands on the graph above indicate periods of recession, and note that those recessions have occurred the last 4 times when there was a drop in housing prices. With the housing prices peaking in Q1 2007, the recession started 1 year later in Q1 2008. Our base case is that the expected drop in housing prices will drive the US economy into recession sometime in 2022 or 2023.
What actions should I take if there is a housing bubble?
Since we believe that the US residential housing market is in a bubble and housing prices have the potential to drop significantly.
We have these recommendations for our clients:
- If you are thinking about selling your home - Consider putting your home on the market as soon as possible
- If you are thinking about buying a home - Consider waiting 12-24 months to purchase a new home as the price could be significantly lower in 2 years than it is today
- If you are thinking about remodeling your home - Consider waiting 12-24 months, as availability of contractors at a lower rate might be easier to find with less competition
If you currently own a home and are planning on staying in it for the long-term, we think you will be fine, and you do not need to take any action. We are concerned about people that need to sell their home soon or buy a new home in the near future.
Your situation is unique so if you need help to work through options to make a decision and understand how buying or selling a home could impact your financial plan, please talk with a Wealth Manager.
How could a housing bubble impact my portfolio?
The rapid rise in interest rates is having a negative impact on the US bond market and for that reason we currently do not own any mutual funds in our models that are only in bonds. You can read about this more in our recent blog: “Rising Uncertainty Increases Market Volatility”.
If the rise in interest rates causes a drop in housing prices, that could push the US economy into a recession as early as 2022, which is likely to have a negative impact on the stock market. We have been getting more defensive with our client portfolios, selling technology, and adding defensive investments, such as gold and dividend funds. Our goal continues to be to try to smooth out the ride for our clients.
We think the increased level of volatility we have seen since the start of the year will likely continue throughout the year. We are monitoring the changes in the economy and stock market daily, and we will continue to actively manage investments as needed to adjust to such changes.
If you have questions on how the topics in this article could impact your portfolio, give your Wealth Manager a call.
Financial Journey Partners - Partners in Your Financial Journey®
Our Financial Journey Partners office is based in San Jose, California. We have clients that live in many states across the country. If you have questions about your investments or financial situation, call us to schedule time to talk about your specific situation.
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1 Federal Reserve Bank of St Louis – Median Sales Price of Houses Sold for the United States
2 Federal Reserve Bank of St Louis – Federal Funds Effective Rate
3 Federal Reserve Bank of St Louis – 30-Year Fixed Rate Mortgage Average in the United State
4 CME Group – CME FedWatch Tool4