Patterns of speculation in real estate and stocks

Abstract

Today there is a hot debate in most developed countries regarding the future of real estate markets. Some economists claim that demand is strong and will remain so, others contend that there may be a small correction in the two next years but, surprisingly, few researchers have tried to take a close took at former price peaks to better understand what may be in store. This is the task we undertake in this paper. The present study shows that stock and property price peaks are ruled by similar mechanisms; moreover in both markets the price earnings ratio constitutes a reliable indicator for assessing the level of speculative fever. The paper closes with a prediction about housing prices in San Francisco over the next four years.

In this study I focus my attention on real estate and stock prices during speculative episodes with special emphasis on the former and their relation with the latter. What do I mean by the expression “speculative episodes”? I will take a very pragmatic position without trying to take side in the debate about the existence of speculative bubbles. When real estate or stock price increases are out of all proportion to other economic factors such as (real) household income or (real) GDP, then one has good ground to think that a speculative mechanism is at work. For instance, when the price of apartments in Hong Kong jumps from USS 2,100 per square meter to over US$ 8,600/sqm (a multiplication by a factor of 4) within six years it is fairly obvious that this is out of pace with overall economic development. Later on in this paper we will give another and more precise criterion based on the price earnings ratio. Incidentally, it should be noted that there is no need to assume that speculative episodes are irrational. The decision of investors are certainly perfectly rational provided one includes into the list of fundamentals the collective factors which build up in those times; more details on this viewpoint can be found in [1] (chapter 3) and [2] (chapter 3).

During the past six years real housing prices have increased by 110 percent in London, 85 percent in Boston, 77 percent in San Francisco. For real estate markets such increases are quite substantial; as a matter of comparison it can be recalled that during the previous speculative episode in 1985-1990, the price increases were about 100 percent in London, 120 percent in Paris and 63 percent in San Francisco and in make an additional payment in order to restore the guaranty level. Needless to say, the higher cost of loans will weight on consumption. (iii) A third mechanism through which lower prices may curtail consumption is the wealth effect documented in [4]. The idea behind this effect is that when people feel more wealthy they are tempted to increase their consumption. The important point is that statistical evidence shows that this effect is about three times stronger for real property than for stocks; basically, the study by Case et al. shows that for every $ 100 their house appreciates homeowners spend $ 6, whereas for stocks the figure is comprised between $ 2 and $ 3.