What happens when thousands of Americans pick up stakes and move from one location to another location? Now add in the fact that while this relocation was happening many more Americans were entering the housing market for the first time to take advantage of low-interest rates.
The answer is that demand outpaces supply. This imbalance causes prices to rise as there are more interested buyers than there are sellers. And just like that, you have a housing bubble.
Bubbles are not new. Just in the last 25 years, we’ve had the dot-com bubble, two housing bubbles, a cannabis stock bubble, and more recently a bubble in speculative stocks known as meme stocks. And those are just a few examples. Asset bubbles can form in just about any sector at any time. As an investor, it’s important for you to understand why they form so you can position your portfolio accordingly.
In this article, we’ll explain what a housing bubble means. We’ll also review the steps retail investors should take to protect and grow their portfolios when the bubble is inflating and deflating.
What is a Housing Bubble?
A housing bubble is a time when housing prices increase sharply. The bubble is fueled by two conditions. First, there is an increase in demand. This can be caused by lower interest rates. Or in the case of the pandemic when many people relocate to one area in a short period of time.
Whatever the root cause, the result is a sharp increase in demand for homes that exceeds the available supply. This creates an environment where home prices rise well above their fair market value. As this dynamic is playing out, speculators will frequently enter the market which drives prices up even higher.
The housing bubble bursts when the buyer/seller ratio returns to a point of relative equilibrium. This may be due to a decrease in demand. It can also be caused by an increase in supply.
Generally speaking, housing bubbles are somewhat predictable. They are fueled by a sharp increase in the credit available to borrowers. This is usually due to either low-interest rates and/or a loosening of the standards required for buyers to get approval for a mortgage.
With that said, a housing bubble will typically burst when interest rates increase or when credit standards become tighter. These usually go hand in hand because when lenders are faced with higher interest rates they become more selective in the requirements they place on borrowers.
That being said, housing bubbles are not as common as equity bubbles. This is due to the transaction size and subsequent carrying costs involved with buying and selling a home. However, once a housing bubble forms it can last longer than an equity bubble.
Why FOMO in the Housing Market Always Proves the Greater Fool Theory
Properly understood, a house can be the most lucrative asset an individual will ever own. Throughout history, price appreciation is a near certainty. So that means the house you buy today is likely to be worth significantly more 10, 20, or 30 years from now.
That explains the mania that happens in a housing bubble. Many people buy homes with the sole intention of selling them for a quick profit. It’s this increase in speculative interest that accelerates the growth of a housing bubble. And because many of these buyers are paying for the homes in cash, the sales can close quickly which causes prices to rise even faster.
That’s when emotion gets involved. As many homeowners see friends, neighbors, and family members selling their homes for large profits, they jump in as well. However, it can be worse for the prospective buyers who race to buy a house for fear of missing out (FOMO). At some point, a buyer becomes an example of the Greater Fool Theory. That is, they are the one that buys a home right before prices collapse.
At best, that means the premium a homeowner pays for the house is now locked up in the house and not available to work for them in other ways. At worst, the homeowner owes more on the house than what it’s worth.
How Can Retail Investors Invest in a Housing Bubble?
In general, the price of real estate and the price of stocks have a low correlation. This means that if one of these asset classes is moving sharply in one direction, the other one is not necessarily moving as sharply.
So unless an investor directly owns real estate, they may not feel the pain of a deflating housing bubble. However, that doesn’t mean that investors shouldn’t take some prudent steps to protect their investments. That’s because there are many stocks that are tied to growth in the housing sector. This includes home improvement stocks, home builder stocks, and even some retail stocks.
It stands to reason that the first step that investors should take is to look at the individual stocks they own. When a housing bubble is first forming, they may want to add stocks that will benefit. This means that fund investors should look closely at the individual components of the funds that they own. If they have significant exposure to companies that may be affected by housing prices, they may look to increase or trim their exposure to the fund depending on the direction of housing prices.
Housing Bubbles are Transitory by Definition
Profiting from a housing bubble requires an active investing strategy. That’s because housing bubbles are short-lived. Even though they may last longer than expected, they do come to an end. And even while the bubble is inflating, the effect it has on certain stocks is transitory.
For example, in 2020, the demand for new home construction coupled with supply chain constraints raised the price of lumber. This made lumber stocks attractive buying opportunities. However, as supply increased and demand slowed down, lumber prices quickly began to fall back in line.
A conservative buy-and-hold strategy would not be effective in this scenario because when prices go down, they will usually fall sharply. An investor will want to set clear price targets and exit the trade when a stock hits those targets.
The Last Word on Housing Bubbles and Investing
Housing bubbles are somewhat predictable occurrences caused by an imbalance in supply and demand. Although they are temporary, they can last longer than investors expect. In general, it’s better to be on the seller's side of a housing bubble. This is because, if the bubble begins to burst, you usually don’t have to sell. On the other hand, as a buyer, you have to be careful about overpaying for a home because once market prices return to normal levels (and they always do) you may find yourself owing more on a home than it’s worth. Or, at best, you’ve missed out on the opportunity cost to deploy that capital in other ways.
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