Saskatoon Housing Market: The Psychology of the Bubble

The best article I have found on bubble market psychology is from Irving Housing Blog.  Bubble Market Psychology: Parts 1 2 3 which take a while to read but are excellent analysis about the US housing bubble and gives us insight to what will happen in Canada.  Totally recommended reading.

"Since 1890 houses have appreciated at 0.7% over the general rate of inflation. Over the long term house values are tied to incomes because most people buy houses with mortgages for which they must qualify based on their income. Inflation keeps pace with wage growth because people will bid up the prices of goods and services with their available income. Therefore, over the long term house prices, wages and inflation all move in concert. There are short-term fluctuations in this relationship due to variations in financing terms, migration patterns, employment, local limits on construction and irrational exuberance, but any such deviations from the mean will be corrected over time by market forces. As an investment, houses serve as a hedge against the corrosive effect of inflation, but over the long term appreciation much in excess of the general rate of inflation is not possible. In this regard, houses are little better than savings accounts as an asset class, and they are inferior to stocks or bonds in the long term."

Now looking at this inflation adjusted graph which shows Western Canadian house prices 1980-2004 ( I added Saskatoon's prices to 2010) and it clearly shows that Saskatoon's have gained more than 0.7% a year over a long time period.

At the peak of the global ( 47 Countries and counting) and US housing bubble, most of the experts got it wrong.  Even the top dogs, Alan Greenspan and Ben Bernakee.  The real estate association, banks and majority of homeowners got it wrong as well.  Did anybody get it right?

There were a few, one guy I will mention is Robert Shiller.  He had warned years earlier that a bubble might be forming in US housing.  He also predicted the dotcom bust years earlier as well.  Here is a quote about why most people bought into the bubble:

Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.

Suppose houses are really of low investment value, but the first person to make a decision reaches the wrong conclusion (which happens, as we have assumed, 40 percent of the time). The first person, A, pays a high price for a home, thus signaling to others that houses are a good investment.

The second person, B, has no problem if his own data seem to confirm the information provided by A’s willingness to pay a high price. But B faces a quandary if his own information seems to contradict A’s judgment. In that case, B would conclude that he has no worthwhile information, and so he must make an arbitrary decision — say, by flipping a coin to decide whether to buy a house.

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment.

As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.

And this is the type of irrational thinking that overcame the emotions of Saskatoon's housing market during the period of the bidding wars. In 2007, people were putting in bids that they would have never thought possible even one year earlier.  People were over bidding on junk houses without a home inspection!
Everybody was caught in the frenzy.  "If everybody is doing it, it must be OK" goes the thinking.  New found wealth was sitting right underneath home owner's feet.  The market was pumped up by people who said Saskatoon's housing was undervalued and that people had better buy now or be priced out forever.

As for what Shiller thinks about Canadian housing has not come true...yet.
In 2008, the Financial Post ran an article Canada may face housing bust: Shiller

Mr. Shiller said there was a natural connection between the United States and Canada.
"I would be surprised that the bubble that appeared in the United States and elsewhere didn't appear in Canada," he said in an interview with the Financial Post. "It's psychology, I think that drives it.

This goes with my thinking that many housing markets while local, are also still synchronized around the world.  So what happened in the United States or in the over 40 countries that have experienced a housing bubble in the past decade can happen here. Housing bubbles have happened in Canada before with stricter lending. It is not different here or this time.