The Real Estate Bubble-has it Peaked?

A lot has happened since we first started writing about the great "Real Estate Bubble" over a year ago. Residential real estate markets nationwide continue to run strong with top prices prevailing. The coastal real estate market has cooled off since earlier this year when it was peaking, but there's still enough activity in this real estate segment to call it "hot." Over and over we've been asked in recent months, "when will the real estate bubble finally burst?" This is not for us to answer since bubble manias by definition are irrational and can reach the theoretical "bursting" point at any time. The bursting point for market bubbles usually occurs about 1-2 years after the actual peak and is a more a function of mass realization and emotional reaction than anything else. The main question of concern at this time is: Has the overall nationwide real estate market peaked?

To answer this question, let's take a look at some leading indicators of real estate prices, namely Real Estate Equity Trusts (REITs). This exercise has proven to be most useful over the past year and the charts are telling a most interesting story at present.

The above chart is a 3-year weekly graph of the Morgan Stanley REIT index (RMS). This is perhaps the most widely followed indication of real estate equities on Wall Street. It has a very toppy appearance and is down appreciably from its early 2002 highs. RMS broke its primary uptrend line back in June. It's still well above its 200-week moving average but the two principle averages, the 100-week and the 200-week, are spreading further apart, which indicates that an important cycle has peaked and is in the declining phase. There is still room for a counter-trend rally in coming months, but we wouldn't be surprised if RMS ended up with a triple-top formation and an inability to penetrate its 2002 highs.

What caused the real estate bubble to begin with? Actually, the bull market in residential and commercial properties has been ongoing since the 1980s and in some regions of the country since the 1970s. What we are witnessing is the end of a long, drawn-out economic expansion which is the result of the 50-60 year Kondratief Wave (K-Wave). Real estate, due to its size and nature, is typically the last major asset to peak once the long-term financial and economic cycles have peaked. For instance, the last meaningful long-term equities cycle, the 30-year cycle, peaked in 1999/early 2000, and this accounts for the Dow Jones Industrial and NASDAQ Composite stock averages peaking at that time. Both have been in bear markets since as the final wave of the 30-year cycle is down into the year 2014-2015.

Physical commodities such as gold and silver are usually the first assets to peak when the K-wave itself peaks (e.g., the 1980 peak in gold). Real estate can benefit from both ends of the K-wave. It benefits as a commodity in the late stages of a K-wave peak, and even after commodity prices peak, real estate prices can continue to boom over many years since real estate can also be considered a type of equity just as much as it can a commodity. In other words, real estate is regarded as having "inherent value." This inherent value concept of real estate is a myth as we'll soon discover. It's actually the last of the great financial myths of the Baby Boomer generation that has not yet been exploded (but will be shortly).

Real estate prices have also had the huge benefit of the greatest debt and mortgage binge in the history of usury banking in recent years. Undoubtedly, a nationwide real estate bubble would be all but impossible but for the easy availability of loans at low varying rates of interest. Debt is the principle cause of most of the financial bubbles and fiascos in the world's history.

Real estate became in many cases the sole beneficiary of Baby Boomer wealth when the stock markets peaked in early 2000. Over the last 2-3 years, the entire post-World War II generation has had to come to grips with the fact that the 50-year bull market in equity prices is over and a substantial part of their retirement wealth and savings has been severely eroded. In reactionary fashion, the great mass of Baby Boomers have put their last eggs into the real estate basket, treating it as a last resort safe-haven-one they think is impervious to even the worst of financial bear markets and economic recessions.

We've used this analogy before, but the final stage of the real estate bull market can be likened to an air mattress that is being deflated-they never deflate evenly but while losing air frequently gather bubbles and air pockets in certain corners of the mattress before all the air eventually escapes. The early 2000s real estate bubble is just that and nothing more, viz., an air pocket with a much larger deflating financial asset bubble. A bubble within a bubble if you will. But like the much larger stock mania that preceded it, the real estate bubble will soon also lose air and early indications point that the deflation process may have already begun.

From a near-term perspective, the 12-year trading cycle has bottomed and that means next year should be an overall beneficial one for stock prices. In other words, we could see a recovery rally lasting into the third or fourth quarter of 2003 based on the enormous short-term pressure that has been lifted from the equities markets. Indeed, a plethora of stock sectors are showing bullish short-term accumulation patterns that could easily resolve to the upside and lead to a spectacular bear market rally in early-to-mid 2003. Obviously, such a rally would be welcome with open arms by Wall Street and the Baby Boomers, who are chomping at the bit to recover some of their lost wealth from the past three years. We can envision a scenario where tons of sideline capital gets plowed into the market in response to a developing uptrend in stock prices.

But just like our proverbial air mattress, all that is really happening is that deflating air is being moved from one corner of the mattress to the other at the expense of more air. This would mean that as stock prices begin to rise and Baby Boomers react by letting their horns back out, real estate prices would suffer as money is funneled away from real estate and into equities. This would have the effect of further expediting the deflation in the real estate bubble that we believe has already begun.

By the Year 2004, it should be evident to everyone that the hopes and dreams of an entire generation for the better part of the last 50 years have been thoroughly crushed. The K-wave is due to have its orthodox bottom at that time and both stock prices and real estate will fall in unison along with the last of the great hordes of accumulated wealth of the Baby Boomer generation.