As with the stock market, while things are going swimmingly up in real estate, many feel wonderful and that the down part of the cycle will not return. When mortgage and rating companies, banks, new fangled investment enterprises, developers, construction businesses, etc. all get on the bandwagon, the regulatory folks just kind of wink and ask for voluntary controls, and individuals or couples are enticed by offers of cheap adjustable loans and not even having to pay down the principle for awhile, all on the assumption things will simply keep going up and up, we are asking for trouble. Well, now we have it, and it will be with us for awhile.
Are our stock markets in better shape? Let's see. The average historical price to earnings ratio of the S&P 500 Index (roughly 75% of the US stock market by capitalization) has been about 15. At the height of the "irrational exuberance" phase of the late 1990s, it got up to about 37. At that level, investors were willing to get just a 2.7% "earnings yield" return on their investments. Today, even after the drops in stock market prices since the beginning of the year, it is about 18, as yet roughly 20% above average. And markets tend over time to return to the mean, so that 20% is probably itself unsustainable for the long-term.
But we are also in a downward earnings cycle. As people see the value of their homes' equity (most folks' biggest investment) declining, they are likely to reign in spending, particularly as there are stresses too on the economy from high energy and health care costs, food price inflation, and layoffs or company closures as the housing recession settles in. With lower earnings, the P/E ratio will be higher, everything else being equal, unless or until there is a more major drop in stock prices.
Or we can review the price to book value ratio. Historically, it has been around 2.0. But today it is around 2.6 for the S&P 500 Index, roughly 30% above the norm.
If we take into account the substantial amount of debt and credit risk currently floating around corporations, hedge funds, and other financial entities, the values prevalent in the markets are even more suspect. Who could have believed that a major financial player like Bear Stearns, a $167 stock only a few months ago, would be worth but $2 a share early this week?
In short, both for common stocks and real estate, prices still appear to be at least 20-30% high, based on historical levels. Since the greed vs. fear fluctuations tend to go too far both on the upside and downside, and to date neither the excesses in stocks nor those in real estate have been fully wrung out, arguably it is not currently irrational to be negative on these two basic types of financial markets.