People Are TalkingŠ
By ROBERT J. SHILLER
The home price boom in the U.S. has had a peculiar form since it began in the late 1990s: Home price increases have been getting stronger and stronger each year, year after year.
According to the inflation-adjusted Case-Shiller home price index from Fiserv CSW, Inc., real U.S. home prices, after falling 0.5% in 1996, rose 2.1% in 1997, 5.4% in 1998, 5.4% in 1999, 5.8% in 2000, 5.8% in 2001, 8.1% in 2002, 8.5% in 2003, and 11.2% in 2004. Each year over nearly a decade was as strong as, or stronger than, the year before it. Other bubble countries, the U.K. and Australia, have not shown this pattern: Growth rates of home prices have been slowing there for years now.
The upward pattern is a little less regular but even more striking in some U.S. cities. In Los Angeles, real home prices, after falling 2.7% in 1996, rose 4.1% in 1997, 10.3% in 1998, 4.5% in 1999, 7.7% in 2000, 7.9% in 2001, 16.9% in 2002, 19.2% in 2003, and 23.2% in 2004.
It doesn't take a lot of expertise to see that there is a trend in home price growth rates in the U.S., and nothing could be more natural than to extrapolate this trend. Just last month sales of existing homes set another record. So why not jump into investments in the real-estate market now?
There is nothing clear on the horizon to break the trend. Of course, the Fed has been raising rates, but it has been doing that for almost a year now with little effect. When they raised rates in 1999 and 2000, and when they cut interest rates drastically in 2001, there was no noticeable effect on the trend in home prices either.
Are those experts preaching efficient markets and diversification just hopelessly naïve? What concrete reason is there not to invest heavily in real estate? Many of us, in fact, are kicking ourselves for not exploiting this obvious investment opportunity years ago.
The biggest uncertainty, for many of us, is just that this pattern of home prices looks like a mass-psychological phenomenon called a bubble. The trend is creating the trend, as more and more herdlike investors notice the trend and pile into the market. If that is what is happening, it can't go on forever. We worry that if we invest in this market, it will be just our luck that it will be a sign that we are among the last investors doing this, and that the market will turn suddenly afterwards.
Some experts are saying that real-estate markets never change suddenly. Actually, what they are saying is only a half truth. Real-estate markets tend to be uneventful from year to year but sometimes do change very fast. Real home prices in Sydney, Australia, rose 12.8% in 2003 and then dropped 2.5% in 2004, a pretty sharp bursting of their bubble. We have seen that sort of thing happen in the U.S., too. Real home prices in high-tech San Francisco rose 26.5% in 2000 and then fell 5.7% in 2001, when the stock-market tech bubble crashed.
Prices quickly rebounded in San Francisco after 2001, but we have no assurance that they will rebound the next time. There is also a lot of historical precedent for gradually sagging real-estate markets. The first half of the 20th century was a time of generally falling real home prices, and real home prices fell over a third in the 50 years from 1894 to 1944. Looking forward, as long as home prices are high relative to construction costs, home builders will have an incentive to increase supply. Home price increases have been fast outpacing construction cost increases during this boom.
So, a sharp reversal in the uptrend in home prices, followed by years of sagging home prices, is certainly a real possibility.
What makes for sudden sharp reversals of trend and sudden drops in home prices? There is no received doctrine among the experts on this point, basically since there are not many major real-estate bubbles to study, and the few that we do have to look at have more special events as part of them than we can possibly sort through. With so many relevant economic factors, it is too easy for economists to overfit their models and delude themselves into thinking that economic fundamentals explain everything, with no need to resort to investor psychology.
But prices in speculative markets are ultimately determined in people's minds, by what they are willing to pay. If people change their minds, prices can change instantly and dramatically. Something has been going on in the minds of Americans that has been leading to an ever-strengthening housing market starting in 1997. That something can change.
There is a widespread perception that something big and exogenous has to happen to break the bubble. People say: Sure, after the real-estate boom of the 1980s, Los Angeles home prices fell 41% in real terms between its peak in late 1989 and its bottom in early 1997, but that was a time when the defense and aerospace industries were contracting in Southern California. They say that contraction is the real explanation of the price drop there.
Special factors may help explain the most extreme price declines, but talk and high prices are the main things that end bubbles. The intensity of talk about the high prices right now is enormous, suggesting an emerging change of public thinking that may signal the end of the bubble.
A similar volume of talk occurred in Australia in late 2003, almost exactly when their housing boom ended. The peak of newspaper articles about the housing bubble in Australia was in September 2003, when the IMF's September World Economic Outlook described an Australian housing bubble and when the Australian Treasury warned of a housing bubble. This was after the Reserve Bank of Australia had been warning of a housing bubble for a year.
Such talk from authorities hasn't happened in the U.S. until now. On May 16, five Federal agencies including the Federal Reserve issued new guidelines for home equity lending, where, they said, lending standards "have not kept pace with the product's rapid growth." On May 20, Federal Reserve Chairman Alan Greenspan said that we are in "a lot of local bubbles" in markets for homes. The volume of public talk about the housing bubble set a new record in May.
Forecasters are naturally wary of predicting turning points. The upward momentum in home price growth rates has been so strong that it seems to be a slam dunk to forecast major home price increases again for the rest of this year. Maybe that is the right forecast. But, beware.
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Mr. Shiller is a professor of Economics at Yale, a principal at Macro Securities Research, LLC., and the author of "Irrational Exuberance," (Princeton, 2005; 2nd edition).