The greater fool theory indicates that economic bubbles occur when optimistic market agents (fools) buy an overvalued asset in anticipation of selling it to more optimistic speculators (greater fools) at higher prices. This vicious cycle continues until the market finally finds the greatest fool of all, who pays the highest price for the asset. And while the U.S. housing market found its greatest fool sometime in 2006, fools have taken over the Canadian housing market as home prices surge well beyond their historical valuations.
Canadian home prices have increased by more than 70% in real terms since 2000, and no matter how you look at it, the Canadian housing market seems unjustifiably overvalued by a significant figure.
Overvalued by all standards
Yale economist Robert Shiller, famous for predicting the U.S. housing collapse, showed that housing prices tend to follow their long-run average real price. There might be periods where housing prices strictly outpace inflation, but these are only to be followed with periods where they lag behind the inflation rate. Currently at 80% above its historical real price average, Canadian housing prices are likely to lose their race with inflation over the next few years.
A possible indicator of housing affordability in Canada is the price-to-household income ratio. Having increased by more than 50% since 2000, the ratio is considered overvalued by around 34% relative to its historical average according to The Economist.
The price-to-rent ratio, analogical to the price-to-earnings ratio for stocks, is perhaps the most appropriate gauge of fundamental value for housing prices. Having almost doubled since 2000, the ratio is currently at 78% above its historical average. A research letter by the Federal Reserve Bank of San Francisco, dating back to 2004, shows that most variance in the price-to-rent ratio occurs due to changes in future returns, not rents. This suggests that if the ratio were to regress to its historical average level in Canada, home prices are likely to adjust, but not rents.
The most daunting of all is that these valuation metrics—price-to-rent, price-to-income and price relative to historical real value average—have surpassed the levels reached by the U.S. housing market in 2006.
Imminent risks
Some might argue that somehow “this time is different,” and that current conditions might not necessarily imply a tendency for reversion to the mean. And while that might be true in some cases, the current conditions are by no way promising for the Canadian housing market.
The high price-to-income ratio might be justified by rock bottom interest rates which help make housing more affordable. However, this unprecedented low interest rate environment is unlikely to last forever, as Mark Carney, Canadian central bank governor, hinted several times at possible interest rates hikes come 2014. According to research by RBC on housing trends and affordability, high interest rates are the most significant threat to home affordability in Canada.
Though interest rates might not rise in 2013, Canadian household indebtedness seems to have reached alarmingly dangerous levels at 1.65 times disposable income—approaching the levels reached in the U.S. before its 2007-2008 housing collapse. Stalling consumer debt accumulation is likely to be a headwind for residential housing.
Beyond the cyclical ups and downs, demographic factors are probably most influential for housing prices in the long run—and the numbers aren’t promising. Housing prices tend to be negatively correlated with the ratio of under 20 or over 64 to those aged between 20 and 64. Professor George Athanassakos from the University of Western Ontario calls this the demographic effect. As baby boomers drop out of the labour force, this ratio will turn upward in 2015 and housing prices will likely go in the opposite direction. While this relationship only implies correlation and not necessarily causation, it seems sensible: individuals between 20 and 64 enjoy increasing credit availability and higher degree of asset accumulation than those in retirement who essentially consume through asset depletion and have decreasing unsecured credit availability.
Looking for the greatest fool?
Before concluding, it is important to note that although the Canadian housing market as a whole is overvalued, the scenario is not necessarily applicable to every submarket. With over 50% of Canadian mortgages being insured by the federal government through the Canadian Mortgage and Housing Corp and lower exposure to subprime mortgages, the Canadian housing market might not necessarily be heading to a U.S. style housing nightmare.
However, demographics, future interest rate hikes, and unsustainable levels of consumer debt accompanied with valuation levels that are reminiscent to those of the U.S. housing market before its collapse all indicate that the Canadian housing market should witness a significant correction.
With housing prices slipping for the 5th consecutive month by a small margin and home sales volume declining by 5.2% year-over-year, the Canadian housing market might have already found its greatest fool.
