okay now that we've taken a look at US
assets we need to spend some time
understanding what an asset bubble is
how one might form and the consequences
of the aftermath and we are specifically
going to examine the housing bubble in
detail because it's the largest bubble
in all of history and will probably be
the most destructive through the long
sweep of history the bursting of asset
bubbles has nearly always been traumatic
social political and economic upheavals
have a bad habit of following asset
bubbles while wealth destruction is a
guaranteed feature along the continuum
of irrational financial behavior it can
be tricky to tell the difference between
a bubble a mania and a mere touch of
exuberance a bubble is reserved for the
height of folly and history is rich with
folly
bubbles used to happen once every
generation or so because it took time to
forget the pain from the damage less
than ten years after the busting of the
dot-com bubble we saw the bursting of
the housing bubble this is simply
astounding and thoroughly unprecedented
so how would we know that we're in an
asset bubble what do they look like and
what can we expect when when burse the
Fed famously likes to claim that you
can't spot one until it bursts but
actually you can and the definition is
pretty simple a bubble exists when asset
price inflation Rises beyond what
incomes can sustain a bubble represents
people abandoning reason and prudence
for hope and greed
out of that prior list of bubbles let's
look at one of the more interesting ones
that occurred in Holland in the 1600s
for some reason the people of that time
became infatuated with tulips saw them
is a surefire path to riches and a
financial mania set in around them yes
we're talking about the flowers that
come from bulbs the bubble began when
beautiful and unique variants and tulip
coloration were developed and bulbs
began trading at higher and higher
amounts as the speculative frenzy built
at the height of the bubble a single
bulb of the most highly sought after
example the semper Augustus commanded
the same selling price is the finest
house on the finest canal but eventually
people figured out that you can actually
grow quite a few tulip bulbs if you set
your mind to it and that perhaps bulbs
were after all just bulbs it is recorded
that the tulip craze did even more
suddenly than it began ending almost in
a single day at the start of the new
selling season in February of 1637 on
that day a silent whistle blew that only
dogs and buyers could hear and prices
crashed this example illustrates two
characteristics of bubbles first that
they are self reinforcing on the way up
meaning that higher prices become the
justification for higher prices and
second that once the illusion is lifted
the game is suddenly and permanently
over a second example of a bubble comes
from the 1700s and goes by the name the
South Sea Bubble the South Sea company
was an English company which was granted
a monopoly to trade with South America
under a treaty with Spain the fact that
the company was rather ordinary in its
profits prior to the government monopoly
did not deter people from speculating
wildly about its potential future value
and the share price rose dramatically
nor did the fact that the company was
billed as a company for carrying out and
undertaking of great advantage but
nobody to know what it is Sir Isaac
Newton when asked about the continually
rising stock price of the South Sea
company said that he could not calculate
the madness of people
he may have invented calculus and also
described universal gravitation but he
also ended up losing over 20,000 pounds
to the bursting bubble proving that
intelligence is often no match for a
bubble in 1720 the South Sea mania took
off display a textbook perfect example
of an asset bubble here we see reflected
two additional essential features of
bubbles they are roughly symmetrical in
both time and price
that is however long it took to create
the bubble is roughly the amount of time
it will take to unwind the bubble and
prices usually get fully retraced if not
a bit more here we can see those
features in perfect form keep an eye on
this shape we'll be seeing it again and
again and again and here in a chart of
the Dow Jones beginning in 1921 we can
see that the stock bubble that preceded
the Great Depression followed roughly
the same trajectory requiring about as
much time to deflate as it did to
inflate and that price is roughly return
to the levels from which they started
and here's the stock price of GM in the
blue line between the years 1924-1930
and a high-tech chip manufacturer
separated by a span of more than 80
years
the fact that bubbles display the same
price behaviors over the centuries and
decades tells us that they are not
artifacts of particular financial
systems but rather are shaped by the
human emotions of greed fear and hope
those have not changed through the years
and this is why you should hold on to
your wallet anytime you hear the words
this time it's different
somewhere along the way people started
to believe this about houses it got to
the point that people began to really
believe that a house was a path to
riches and even better it was a magical
path that would transport you to Easy
Street even if you sat on your sofa the
whole time drinking beverages
now there's simply no way for this to be
true and we should have known better but
bubbles usually have their way with the
masses regardless over the long haul
house prices will be set by whatever it
costs to build a new house
meaning that inflation will ultimately
dictate house prices this amazing chart
of inflation adjusted house prices
created by Robert Shiller reveals that
between 1890 and 1998 house prices
tracked the rate of inflation very
closely in this chart anytime the line
is rising houses are appreciating faster
than the rate of inflation and anytime
the line is falling they are losing
ground compared to inflation over this
entire 118 year period house prices
averaged 101 point two meaning that
inflation adjusted house prices are
roughly comparable across this entire
sweep of history see this little bump
right here that was a property bubble
that I still remember clearly because it
impacted the Northeast where I lived at
the time and I got to ride my bike
through abandoned construction projects
which was great fun notice that this
property bubble returned a baseline in a
fairly symmetrical fashion as did the
property bubble of 1989 well if those
were property bubbles then what's this
this housing bubble has no historical
precedent and is massively out of
proportion to anything we've ever
experienced before there's nothing even
remotely close to it in magnitude so we
are left without any history to guide us
as to what the impacts are likely to be
and also note that this bubble did not
suddenly begin in 2004 it began in 1998
and ahead eclipses the past - by 2000
you might ask yourself if the Federal
Reserve had access to this data and knew
we had a property bubble on our hands as
early as 2000 why did they continue to
aggressively lower interest rates to 1%
and then hold them there for a year
between 2003 and 2004
well that's a darn good question and
I'll get to that in a minute based on
this chart where and when might we
predict that this bubble will finally
bottom out well symmetry suggest the
bottom will be somewhere around 2015
while history suggests that prices will
decline by roughly 50% in real terms the
other way we could look at this is in
terms of affordability again over the
long haul it is impossible for median
house prices to rise faster than median
incomes why because the amount that
people can afford to pay sets limit on
house prices here's a chart put together
that compares median incomes to median
house prices the bubbles of 1979 and
1989 are not very dramatic on this graph
but they're they are marked by the black
arrows
the fact that median incomes did not
deviate very far from those prior bubbly
house prices helped to limit the impact
of the bursting of those bubbles painful
though they were because incomes and
house prices did not have to travel very
far to once again meet up this time
again we have no historical precedent
for the gap between income gains and
house prices and we see disturbing signs
as early as 1999 that things were
getting off track based on income gains
alone
how much would house prices have to fall
to bring these lines back together the
answer is to 34 percent nationally
indicating that there's still a long way
to go yet given the propensity of
bubbles to overshoot to the downside we
can't discount that a 40 percent or even
50 percent decline is in the cards here
we might also guesstimate that house
prices would bottom somewhere in the
vicinity of 2012 to 2015
remember a bubble exists when asset
price inflation Rises beyond what
incomes can sustain and that's exactly
what we see in this chart
so where was the Fed during all of this
well they were busy writing research
papers convincing themselves that there
was no housing bubble as seen in this
2004 Fed study entitled our home prices
the next bubble
the main summary of the study started
off on a good note stating home prices
have been rising strongly since the mid
1990s prompting concerns that a bubble
exists in this asset class and that home
prices are vulnerable to a collapse that
could harm the US economy but then the
main conclusion of the paper veered
sharply off into a ditch reading a close
analysis of the US housing market in
recent years however finds little basis
for such concerns the marked upturn in
home prices is largely attributable to
strong market fundamentals home prices
have essentially moved in line with
increases in family income and declines
in nominal mortgage interest rates
essentially moved in line with increases
in family income what one of the most
widely known facts of our time is that
family incomes did not move up at all on
an inflation adjusted basis during the
housing boom and is one of the principal
economic failures of the first decade of
the millennium
this just goes to show that the Federal
Reserve is either stocked with inept or
biased researchers and of the two I'm
not sure which makes me feel worse about
our chances of safely navigating through
this mess
but the feds researchers were simply
doing what millions of people did namely
falling prey to believing that somehow
this time it's different but that's just
how bubbles are people take leave of
their senses use all manner of
rationales to justify their positions
but then suddenly one day the illusion
lifts and what seemed to be unassailably
true no longer makes any sense at all
once that day happens the fate of the
bubble is reduced to measuring the speed
of its collapse
while it's tempting to lay the blame for
what's happening on the housing bubble
it's important to remember that the
dramatic rise in house prices was itself
just a symptom of a credit bubble run
amok total credit at the end of 2000
when the stock bubble was bursting stood
at 27 trillion dollars by the end of
2007 it stood at an astounding 48
trillion dollars this 21 trillion dollar
increase in borrowing is five times
larger than the increase in u.s. GDP
over the same period of time any attempt
to understand the housing bubble has to
be viewed against the backdrop of this
massive increase in debt but as we noted
in an earlier chapter this credit bubble
has been going on for 25 years unwinding
a multi-generational debt binge is going
to require some enormous changes in
attitudes and habits
one reason that any bubble but
especially a housing bubble like this
one is so destructive is because so many
bad investments are made along the way
too many houses were built too many
shopping centers and too many condos and
nearly all of them too large and ill
positioned for a future of expensive
energy sorry to say but all those
trillions of dollars were wasted and
worse stole opportunities from the
things that needed money more the
Austrian School of Economics has a very
crisp and historically accurate
definition of how a credit bubble ends
according to Ludwig von Mises there is
no means of avoiding the final collapse
of a boom brought about by credit
expansion the alternative is only
whether the crisis should come sooner as
a result of a voluntary abandonment of
further credit expansion or later as a
final and total catastrophe of the
currency system involved
this is a view I happen to ascribe to
and explains my strong preference for
placing my wealth out of the path of a
potential dollar collapse as a nation
we've undertaken desperate measures to
avoid abandoning the continuation of our
credit expansion leaving a final
catastrophe of the currency as our most
likely outcome as for the timing it
could hardly be worse dealing with a
bursting housing bubble is hardly the
sort of challenge we needed this
particular moment in history but here we
are the stewardship and vision displayed
by the Federal Reserve in Washington DC
and bringing all of this about has been
utterly atrocious so what can we expect
from a collapsing credit bubble simply
put everything that fed upon and grew as
a consequence of too much easy credit
will collapse I am especially leery of
financial stocks low-grade bonds and of
course real estate
I see very few conventional ways to
protect one's wealth and so I invite you
to begin asking yourself and if you have
one your financial advisor some very
hard questions about the safety of your
holdings you'll be glad you did remember
this time it's probably not different
please join us for the next chapter
where we will explore the extent to
which we have been telling ourselves
Pleasant half-truths and other
falsehoods which I call fuzzy numbers
thank you for listening