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October 29, 2016 | Three Case-Shiller Cities That Are In the Bubble Zone

Robert Campbell

Robert Campbell is a real estate analyst and economist. He's been publishing The Campbell Real Estate Timing Letter since 2002. His book (Timing the Real Estate Market) presents a clearly defined method for predicting the peaks and valleys of real estate cycles.

In my July 2016 Timing Letter, I showed how the Case-Shiller 20-City Index had been rising in a tight and relatively modest 5.4%-5.8% year-over-year price range since September 2015.

This lack of increasing price acceleration and relatively modest price growth suggests that speculation in the broad U.S. housing market is not running rampant at this time, which in turn suggests that – at least on a national level – we are probably not in a dangerous and unsustainable asset bubble right now.

However what may be true on a national basis, may or may not be true on an individual city-by-city basis. To a large degree, all housing is local, right?

As illustrated in the chart below, I have identified three Case-Shiller cities that
I believe are in a bubble, or close to it: San Francisco, Denver, and Dallas.

I would first like to define what a bubble is.

The word “bubble” is thrown around much too loosely (and subjectively) by most people, however here’s my definition: a bubbleis any asset whose price has moved at least two standard deviations above its longer-term statistical mean (or norm).

Thus when a two standard deviation price event occurs in any asset – including real estate – the records of history show that it is almost a 100% dead-certainty that a severe price correction lies in wait – whereby prices eventually revert back to their historical mean, or close to it.

It’s kind of like a major league baseball player that has a 10 year batting average of .250 – but then hits .400 for a couple of months. Is the .400 batting average sustainable? Probably not, and it will therefore only be a matter of time until this “hot” hitter goes into a terrible slump that will cause his spectacular hitting streak to end and revert back to his historical norm – which will likely be a far less spectacular (but sustainable) average of roughly .250.

San Francisco’s Housing Market

The Case-Shiller Index for San Francisco (which covers five different Bay Area counties) has risen a staggering 82.3% in the last four years – which is an average annual rise of 20.6% per year! This rapid and massive price move almost surely is greater than a two standard deviation event (in fact it’s probably above 3) – which by definition makes the San Francisco housing market a bubble.

Housing prices in San Francisco County (i.e. “The City”) have gone up even faster than the Case-Shiller Index for the Bay Area as a whole. They have risen approximately 100% in the last four years – which represents an average annual rise of 25% per year.

Is this beginning to sound like a bubble?

That’s because it is.

Does that mean now would be a good time to sell? No, not necessarily. The reason being is that the trend is still up – and as we know from the 2000-2006 episode, asset bubbles can inflate more than most people ever believed possible.

Nevertheless, because San Francisco home prices have risen too high and too fast – I therefore believe it is only a matter of time before this overly-inflated housing market takes another fall similar to the one that occurred from 2006 to 2009 – which took San Francisco housing prices lower by 46.1%.

Let’s now look at the Denver and Dallas housing markets – and let me explain why I think they too may be in the midst of housing bubbles.

Are Denver and Dallas Also in Housing Bubbles?

Compared to San Francisco, I am not nearly as confident that Denver and Dallas are in housing bubbles, but an analysis of the numbers tell me that they could be – or at least will be in bubbles soon if housing prices in these two cities keep rising at their current rates, which are about double the national average.

During the bubble years of 2000 to 2006, the Case-Shiller 20-City Index rose 84.6%. However, if you look at the chart on the previous page, you’ll see that Denver and Dallas did not get as caught up in the speculative mania that gripped the rest of the country – the proof being that housing prices only rose 40.3% and 26.3% respectively in those two cities during the bubble period.

National housing prices fell 27.4% during the crash, Denver (-14.3%) and
Dallas (-10.8) fell far less.

Studying the Past to Help Predict the Future

If we look at the recent 2000-2012 time period through good housing markets and bad, it suggests that Denver and Dallas tend to experience price movements that are about 50-60% less than the Case-Shiller national average.

However since the start of the housing recovery in 2012, Dallas (+34.5%) and especially Denver (+47.0%) has outperformed the national rate of home price appreciation (+31.5%) – and not under-performing it like they did during the bubble years.

Furthermore, Denver home prices are now slightly higher than the national average, which hasn’t been the case since 2002. Plus, home prices in Denver rose 40.3% during the bubble years but are now up almost 20% more than that since 2012.

This suggests to me that Denver’s strongly performing housing market has probably been fueled by excess speculation and irrational exuberance since 2012 – which is the fuel that creates an asset bubble.

What about Dallas?

Dallas, although to a lesser degree than Denver, is also showing signs that it too may be in a housing bubble. Like Denver, home prices in Dallas have not only appreciated more than the national averages since 2012 – but they have also appreciated more during the last four years (+34.5%) than they did during the entire six year bubble period (+26.3%) – which is a 31.2% increase.

And lastly, trust what your eyes are telling you. Take another look at the chart on the previous page. Relative to the historical price patterns that occurred from 2000 to 2012, do the recent rise in home prices from 2012 to 2016 for both Denver and Dallas look ordinary to you – or does it look like they are overdone?

What does this mean to investors?

It means when this housing market upcycle ends, the downturn in home prices in Denver and Dallas will likely be worse than the national average – and home prices in San Francisco will likely be much worse.

That’s how I see things. How about you?

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