Asset bubbles according to Jeremy Grantham: Applications to the Canadian real estate market

Intro

Jeremy Grantham is a living stock market legend.  He is a deep value investor who has brought new concepts to the world of stock market investing.  He championed the ‘small cap value’ approach and has a stellar track record.  He is currently the Chairman of the Board of Grantham Mayo Van Otterloo (GMO), a Boston-based asset management firm.  He currently oversees over $100 billion in assets.

One of his great strengths has been his ability to spot bubbles and profit from them.  He is a student of history, and I would consider him among the great thinkers like Robert Shiller when it comes to asset bubbles.  He is currently leading the most comprehensive study on asset bubbles ever attempted: a meta analysis of 320 completed asset bubbles including commodity, stock market, currency, and real estate bubbles.

When Grantham speaks about bubbles, it’s worth listening.  But before I turn it over to him, let’s take a minute to discuss what an asset bubble is.

Defining an asset bubble:

There was an interesting discussion in the comment section of John’s guest post from over the weekend.  There is no universally accepted definition of an asset bubble.  Various commenters suggested a precise definition or at least components that should be included in any definition:

“An economic bubble is loosely defined as a significant, usually exponential, departure from an underlying long term trend.”   -John

“I would argue no, it’s not the rate of change of a fundamental metric that defines a bubble, but its valuation. People can disagree on whether Google should trade for 15x earnings or 25x earnings given its current earnings growth rate. However, I don’t read about anyone believing that it should trade for 50x.  Expanding beyond equities, if an asset price cannot be justified by fundamentals, that’s where you’ve got an overvalued market. Is it necessarily a bubble? That’s more difficult to say.”  -Lumpen

“A speculative bubble is usually caused by exaggerated expectations of future growth, price appreciation, or other events that could cause an increase in asset values. This drives trading volumes higher, and as more investors rally around the heightened expectation, buyers outnumber sellers, pushing prices beyond what an objective analysis of intrinsic value would suggest.”  -HHV

All excellent points.  For an interesting visual interpretation of what constitutes an asset bubble, check out Chris Martenson’s video on the topic:

There are several proposed components of an asset bubble that are nearly universally accepted:

1)  They involve a rapid expansion in the value of the asset class in question, typically ending in a ‘blow off’ top with prices trends moving nearly vertical relative to the long-term trend line.  However, as one commenter pointed out, this depends on your time horizon.  Even small rates of compounded growth produce exponential curves given a long enough time line.  Consider the total human population throughout history.  We have a growth rate of less than 2% throughout history.  Yet all compound growth, no matter how low, always ends up producing a hockey stick formation as can be seen in our human population graph.  So this one’s a bit tricky.  There’s certainly more to it than this.

Let me add to this that not only do they rise rapidly in nominal value, but more importantly they deviate markedly from long-term measures of fundamental value…..be they the P/E ratio for stocks or the price/income or price/rent ratio for houses.  In other words the rise in value significantly outpaces the factors upon which the asset price was historically based.

2)  They involve mass psychology.  They are virtually always accompanied by a ‘new era’ or ‘this time it’s different’ mentality which people use to justify otherwise unjustifiable prices.  While these stories always contain an element of truth, they are wholly inadequate in supporting asset values at their lofty levels.  Think of the dot-com stocks of the late 90s or, I would suggest, the ‘Hot Asian Money’ new paradigm story in Vancouver.

3)  They are typically accompanied by cheap and readily available credit.

4)  They occur during periods of economic prosperity.  I would also add that if the accompanying expansion in credit is particularly large and if the participation rate is high among the broad population, the forming bubble eventually BECOMES the economic prosperity as it directs the flow of credit into the broader economy and buoys employment and GDP growth….for a while.

Does Canada meet the definition of a housing bubble?

The jury is certainly out when it comes to the broader Canadian housing market.  Certainly there is widespread overvaluation relative to fundamentals, but that doesn’t necessarily imply a bubble.  However it is worth considering the macro picture.  There most certainly is a credit bubble in Canada.  It’s difficult to distinguish a credit bubble from a real estate bubble when 70% of credit is mortgage-derived.  The bottom line is that strong deflationary forces will be put in motion when the inevitable shift towards debt repayment and savings begins.  This will wreak havoc on leveraged assets priced in our currency.  If this is accompanied by commodity price inflation, look out.  This one-two punch has the potential to significantly affect even the most reasonably priced Canadian market.

For what it’s worth I do think that real estate in most locales is in for a bumpy ride and I do think that on aggregate, the housing market is in bubble territory.  I would strongly consider sitting on the sidelines for a couple years if you are contemplating buying.

All that being said, there is little doubt in my mind that certainly centres are experiencing bubbles for all of the reasons mentioned above.  Let’s consider a graph comparing the change in US and Canadian real estate over the past 10 years:

Simply based on the rules above, we see that we have a pretty strong increase in house prices over a relatively short period of time.  We know that we have lived through a period of cheap, easy credit.  We know that consumer sentiment on real estate is still wildly bullish.  The one thing that is not necessarily present in all cities is a ‘new era’ mentality, though it is rampant in Vancouver.

With all that in mind, let’s turn our attention to Mr. Grantham.

Grantham on asset bubbles:  Their importance to investors and why they occur

The full must-read report can be read here.  The portion on bubbles is in section 2.   I will highlight a few of the important quotes and add some commentary.

“But asset bubbles don’t spring out of the ground entirely randomly. They usually get started based on something real – something new and exciting or impressive, like unusually strong sales, GDP, or profits, which allow the imagination to take flight. Then, when the market is off and running, momentum and double counting (among other factors) allow for an upward spiral far above that justified by the fundamentals.  There is only one other requirement for a bubble to form, and that is a generous supply of money. When you have these two factors – a strong, ideally nearly perfect economy and generous money – you are nearly certain to have a bubble form.”

This encompasses a few of the key points from above.  If we make the connection to real estate, we had strong, organic economic growth since the late 90s.  We ran ran budget surpluses in the early 2000s.   After the dot-com bubble burst, two additional psychological factors were kicked into play:  interest rates cratered and many people were spooked away from stocks and towards other assets.

Since 2006, we’ve had a fairly stable erosion in lending standards with down payments dropped to 5% (with a brief foray into 0 down mortgages).  This is a far cry form the standard 20% down that had been the minimum criteria for most of CMHC’s existence.  Additionally, amortization lengths were extended from 25 years to a maximum of 40 years.  After March 18, this mistake will largely be corrected as the max amortization will move back to 30 years.

“…In the efficient market view, when a bubble forms, it is seen as a paradigm shift – a genuine shift in the very long-term value of an asset class or an industry. If that were the reason – a fundamental change, not the package of basically behavioral factors we’ve described – then what would happen following these peaks in an efficient world?  Why, the prices would wander off on an infinite variety of flight paths, half of them upwards and half downwards with, I suppose, one or two nearly sideways.  What happens exactly in our inconvenient real world? All of them go back to the original trend, the trend that was in place before the bubble formed.”

All of the leading experts on asset bubbles unanimously agree that the likelihood of an asset bubble correcting itself by moving sideways is virtually zero.  Of course that leaves the question of what exactly constitutes a bubble.  Let me just say that those hoping our priciest housing markets will pull off this near-miraculous feat will very likely be sorely disappointed.

“Newton had the great good luck to get into the South Sea Bubble early. He made a really decent investment and a very quick killing, which mattered to him. It was enough to count. He then got out, and suffered the most painful experience that can happen in investing: he  watched all of his friends getting disgustingly rich. He lost his cool and got back in, but to make up for lost time, he got back in with a whole lot more (some of it borrowed), nicely caught the decline, and was totally wiped out. And he is reported to have said something like, “I can calculate the movement of heavenly bodies but not the madness of men.”

This quote gives us some great insight into the psychological factors involved in bubble formation.  They are driven by greed and envy on the way up, and fear on the way down.  Let’s recall that Isaac Newton was an exceptionally intelligent person who had amassed a significant fortune, yet he was as susceptible to the same human frailties that afflict all of us.   We are all prone to group-think and herd mentality.  We take great comfort in being part of a crowd.

It also helps illustrate that at some point in the bubble cycle, rising prices become the justification for rising prices.  The demand cannot be met quickly enough leading to price rises….which encourage others to jump in as they see the gains made by friends…..and demand/prices increase further, not supported by any measure of fundamentals but by simple herd mentality.

“Let me end by emphasizing that responding to the ebbs and flows of major cycles and saving your big bets for the outlying extremes is, in my opinion, easily the best way…to add value and reduce risk. In comparison, waiting on the railroad tracks as the “Bubble Express” comes barreling toward you is a very painful way to show your disdain for macro concepts…. The really major bubbles will wash away big slices of even the best…portfolios. Ignoring them is not a good idea.”

While Grantham’s comment is directed towards the stock market, its application to our current real estate market warrants consideration.  To paraphrase, with current prices at such lofty levels relative to rent in many large centres, it certainly suggests that a prudent approach is patience as the ebb and flow of the current market dynamics plays out over the next few years.  If the price/rent ratio is significantly higher than the historical norm, logic would suggest that renting and saving the difference is the prudent route.  Even in smaller markets where valuations are not as extreme, though certainly pricey, it is possible to find excellent homes to rent for a fraction of ownership costs.

For more on how to find an excellent rental house, check out this post.

It’s also worth considering the financial implications of a sideways market in some of the bubblier markets like Vancouver.  In markets like Vancouver, it is exceptionally difficult to explain just how the current price trajectory can be sustained over the next few years.  Even most of the ardent housing bulls acknowledge that a sideways market is the best case scenario.  While momentum will likely take prices higher for a while, there is a lot of dead air under the market.  The actual calculations of the financial implications of home ownership vs. renting was discussed in an earlier post, so I won’t rehash it here.  Bottom line is that Grantham’s suggestion that you get out of the way of the ‘Bubble Express’ and save your capital for the correction which is overwhelmingly likely to occur is well founded.

Even if you don’t live in one of the bubblier areas, there is a very good chance that you will have the opportunity to purchase real estate in the next few years when sentiment is not nearly as bullish, fear reigns, buyers are much more scarce, sellers are abundant, and deals much more plentiful.

Cheers,

Ben