Wednesday, December 07, 2005

Evidence Supports Bubble Theory

There's some very interesting data in a new report entitled "Is There a Housing Bubble in Humboldt County?", by Dr. Erick Eschker, Director of the Index of Economic Activity for Humboldt County, an ongoing collaborative research project involving Humboldt State University faculty and students and participation by many private businesses and government agencies. Soren Messner-Zidell, a student in the Department of Economics at Humboldt State University, is a co-author of the report.

The executive summary, which can be found at this link, draws out the P/E ratio depicted in the chart above as evidence of a housing bubble even in this small, remote county of about 130,000 people. Here's an abridged excerpt from the summary:
The most common way to look for a housing bubble is to look at changes in the P/E ratio, which is the price of the house divided by the current yearly rent that the house could earn, after adjusting for maintenance costs.

… The rapid rise in the P/E ratio in 2003 and 2004 was more pronounced than any change in the P/E ratio over the period 1989-2004. Compared to 1989-2002, the P/E ratio in 2003- 2004 averaged almost five points or 33% more. This P/E ratio increase is not as great as that which is observed in some housing markets, but it is greater than others in which a housing bubble is thought to exist. There is some evidence that low interest rates and vacancy rates may explain part of the increase in the P/E ratio, but other market fundamentals cannot explain the rise in the P/E ratio. We conclude that the P/E evidence is consistent with a housing bubble in Humboldt County.

We cannot predict what will happen to housing prices in the future. If there is a bubble, and if the bubble pops, then one possibility is an actual decline in housing prices, as was experienced by many regions in California over 1991-1992. This decline may be mild or severe. Another possibility is a very long period, perhaps a decade or longer, of stagnant house prices.
Humbolt County facts and figures are available from the US Census Bureau.

— The Boy in the Big Housing Bubble