Okay, now that we’ve taken a look at US assets, we need to spend some time understanding what an asset bubble is, how one might form, and the consequences of the aftermath. And we are specifically going to examine the housing bubble in detail, because it’s happening right now and is the largest bubble in all of history and will probably be the most destructive.

Through the long sweep of history, the bursting of asset bubbles has nearly always been traumatic. Social, political, and economic upheavals have a bad habit of following asset bubbles, while wealth destruction is a guaranteed feature.

Along the continuum of irrational financial behavior, it can be tricky to tell the difference between a bubble, a mania, and mere touch of exuberance. A bubble is reserved for the height of folly, and history is rich with folly.

Bubbles used to happen once every generation or so, because it took time to forget the pain from the damage. Today we are facing the bursting of a second major asset bubble, housing, spaced less than ten years from the bursting of the dot-com bubble. This is simply astounding and thoroughly unprecedented.

So how would we know that we’re in an ‘asset bubble’? What do they look like, and what can we expect when one bursts?

The Fed famously likes to claim that you can’t spot one until it bursts. But actually you can, and the definition is pretty simple: A bubble exists when asset price inflation rises beyond what incomes can sustain. A bubble represents people abandoning reason and prudence for hope and greed.

Out of that prior list, let’s look at one of the more interesting bubbles that happened in Holland in the 1600’s. For some reason, the people of that time became infatuated with tulips, saw them as a sure-fire path to riches, and a financial mania set in. Yes, we’re talking about the flowers that come from bulbs. The bubble began when beautiful and unique variants in tulip coloration were developed, and bulbs began trading at higher and higher amounts as the speculative frenzy built. At the height of the bubble, a single bulb of the most highly sought after example, the Semper Augustus seen here, commanded the same selling price as the finest house on the finest canal.

But eventually people figured out that you actually could grow quite a few tulips if you set your mind to it, and that perhaps bulbs were, after all, just bulbs.

It is recorded that the tulip craze ended even more suddenly than it began, ending almost in a single day at the start of the new selling season in February of 1637. On that day, a silent whistle blew that only dogs and buyers could hear, and prices crashed.

This example illustrates two characteristics of bubbles. First, that they are self-reinforcing on the way up, meaning that higher prices become the justification for higher prices, and second, that once the illusion is lifted, the game is suddenly and permanently over.

A second example of a bubble comes from the 1700’s and goes by the name “The South Sea Bubble.” The South Sea Company was an English company granted a monopoly to trade with South America under a treaty with Spain. The fact that the company was rather ordinary in its profits prior to the government monopoly did not deter people from speculating wildly about its potential future value, and the share price rose dramatically. Nor did the fact that the company was billed as “A company for carrying out an undertaking of great advantage, but nobody to know what it is."

Sir Isaac Newton, when asked about the continually rising stock price of the South Sea Company, said that he “…could not calculate the madness of people.” He may have invented calculus and described universal gravitation, but he ended up losing over 20,000 pounds to the bursting bubble, proving that intelligence is no guarantee of avoiding being swept up in the animal instincts of a still-expanding bubble.

In 1720, the mania took off, displaying a text-book-perfect example of an asset bubble. Here we see reflected two additional essential features of bubbles: They are roughly symmetrical in both time and price. That is, however long it took to create the bubble is roughly the amount of time it will take to unwind the bubble, and prices usually get fully retraced, if not a bit more. Here we can see those features in perfect form. Keep an eye on this shape. We’ll be seeing it again, and again, and again.

And here in a chart of the Dow Jones, beginning in 1921 we can see that the stock bubble that preceded the Great Depression followed the same rough trajectory, requiring about as much time to deflate as it did to inflate, and that prices roughly returned to the levels from which they started.

And here’s the stock price of GM in the blue line between the years 1912 and 1922, and Intel in the red line between 1992 and 2002, periods during which both stocks were swept up in bubbles. Here we might also note that the price data looks very similar for both stocks, despite the fact that they reflect a car company and a high tech chip manufacturer separated by a span of 80 years.

The fact that bubbles display the same price behaviors over the centuries tells us that they are not artifacts of particular financial systems, but rather are shaped by the human emotions of greed, fear, and hope. Those have not changed through the years, and this is why you should hold onto your wallet any time you hear the words this time it’s different.

Somewhere along the way, people started to believe this about houses. It got to the point that people began to really believe that a house was a path to riches. And, even better, it was a magical path that would transport you to easy street even if you sat on your sofa the whole time drinking beer.

Now, there’s simply no way for this to be true, and we should have known better, but bubbles usually have their way with the masses. Regardless, over the long haul house prices will be set by whatever it costs to build a new house, meaning that inflation will dictate house prices.

This amazing chart of inflation-adjusted house prices, created by Robert Shiller, reveals that between 1890 and 1998, house prices tracked the rate of inflation very closely. Any time the chart line is rising, houses are appreciating in price faster than the rate of inflation, and any time the line is falling, they are losing ground compared to inflation.

Over this entire 118-year period, house prices averaged 101.2, meaning that inflation-adjusted house prices are roughly comparable across this entire sweep of history. Real estate prices were stable compared to inflation, then fell before and during the Great Depression, stabilized again, and then rose dramatically after the war.

See this little bump right here? That was a property bubble that I still remember clearly, because it impacted the Northeast, where I lived at the time, and I got to ride my bike though abandoned construction projects. Notice that this property bubble returned to baseline in a fairly symmetrical fashion, as did the property bubble of 1989.

Well, if those were property bubbles, then what’s this? This housing bubble has no historical precedent and is massively out of proportion to anything we’ve ever experienced before. There is nothing even remotely close to it in magnitude, so we are left without any history to guide us as to what the impacts are likely to be.

And also note that this bubble did not suddenly begin in 2004; it began in 1998 and had eclipsed the past two by 2000. You might ask yourself, “If the Federal Reserve had access to this data, and knew we had a property bubble on our hands as early as 2000, why did they continue to aggressively lower interest rates to 1% and hold them there for a year between 2003 and 2004?”

That’s a darn good question, and I’ll get to that in a minute.

Based on this chart, where and when might we predict this bubble to finally bottom out? Well, symmetry suggests the bottom will be somewhere around 2015, while history suggest that prices will decline by roughly 50% in real terms.

The other way we could look at this is in terms of affordability. Again, over the long haul it is impossible for median house prices to rise faster than median incomes. Why? Because the amount that people can afford to pay sets a limit on house prices.

Here’s a chart I put together that compares median incomes to median house prices. The bubbles of 1979 and 1989 are not very dramatic on this graph, but there they are, marked by black arrows. The fact that median incomes did not deviate very far from those prior bubbly house prices helped to limit the impact of the bursting of those bubbles, painful though they were, because incomes and house prices did not have to travel very far to meet up once again.

This time? Again, we have no historical precedent for the gap between income gains and house prices, and we see disturbing signs as early as 1999 that things were getting off track. Based on income gains alone, how much would house prices have to fall to bring these lines back together? The answer is 34% – nationally – indicating that there’s a long way to go yet. Given the propensity of bubbles to overshoot to the downside, we can’t discount that a 40% to 50% decline is in store. Here we might also guesstimate that house prices would bottom somewhere in the vicinity of 2012 to 2015. Remember, a bubble exists when asset price inflation rises beyond what incomes can sustain. And that’s exactly what we see here in this chart.

So, where was the Fed during all of this? They were busy writing “research” papers convincing themselves that there was no housing bubble, as seen in this 2004 Fed study entitled, “Are Home Prices the Next Bubble?”

The main summary of the study started off on a good note, stating, “Home prices have been rising strongly since the mid-1990s, prompting concerns that a bubble exists in this asset class and that home prices are vulnerable to a collapse that could harm the US economy.”

But then main conclusion of the paper veered sharply off into a ditch, reading:

“A close analysis of the U.S. housing market in recent years, however, finds little basis for such concerns. The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.”

“Essentially moved in line with increases in family income?” What? One of the most widely known facts of our time is that family incomes have not moved up at all over the past 8 years on an inflation-adjusted basis and is one of the principal economic failures of this decade. This just goes to show that the Federal Reserve is either stocked with inept or biased researchers, and, of the two, I am not sure which makes me feel worse about our chances of pulling through this mess.

But the Fed’s researchers were simply doing what millions of people did; namely, falling prey to believing that somehow “this time it’s different.” But that’s just how bubbles are. People take leave of their senses, use all manner of rationales to justify their positions, but then, suddenly one day the illusion lifts, and what seemed to be unassailably true no longer makes any sense at all. Once that day happens, the fate of the bubble is reduced to measuring the speed of its collapse.

Why is any of this important to us? Because we are going to be living with the after-effects for a very long time.

While it’s tempting to lay the blame for what’s happening on the housing bubble, it’s important to remember that the dramatic rise in house prices was itself just a symptom of a credit bubble run amok.

Total credit at the end of 2000, when the stock bubble was bursting, stood at $27 trillion dollars. By the end of 2007, it stood at an astounding $48 trillion dollars. This $21 trillion increase in borrowing is five times larger than the increase in US GDP over the same period of time. Any attempt to understand the housing bubble has to be viewed against the backdrop of this massive increase in debt.

But as we noted in an earlier chapter, this credit bubble has been going on for 25 years. Unwinding a multi-generational debt-binge is going to require some enormous changes in attitudes and habits.

One reason that any bubble, but especially a housing bubble like this one, is so destructive is because so many bad investments are made along the way.

Too many houses were built, too many shopping centers, too many condos, and nearly all of them too large and ill-positioned for a future of expensive energy. Sorry to say, but all those trillions of dollars were wasted, and, worse, stole opportunities from the things that needed that money more.

The Austrian school of economics has a very crisp and historically accurate definition of how a credit bubble ends. According to Ludwig Von Mises:

“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

This is a view I happen to ascribe to and explains my strong preference for placing my wealth out of the path of a potential dollar collapse. As a nation, we’ve undertaken desperate measures to avoid abandoning the continuation of our credit expansion, leaving a final catastrophe of the currency as our most likely outcome.

As for the timing? It could hardly be worse. Dealing with a bursting housing bubble is hardly the sort of challenge we need at this particular moment in history, but here we are. The stewardship and vision displayed by the Federal Reserve and Washington, DC in bringing this all about have been utterly atrocious.

So what can we expect from a collapsing credit bubble? Simply put, everything that fed upon and grew as a consequence of too much easy credit will collapse. I am especially leery of financial stocks, low grade bonds, and of course, real estate.

I see very few conventional ways to protect ones wealth, and so I invite you to begin asking yourself (and, if you have one, your financial advisor) some very hard questions about the safety of your holdings. You’ll be glad you did.

Remember, this time it’s probably NOT different.

Please join us for the next chapter, where we explore the extent to which we have been telling ourselves pleasant half-truths and other falsehoods, which I call “Fuzzy Numbers.”

Thank you for listening.