Financial bubbles are much harder to spot than people realize

The spectacular bubble in the stock market 15 years ago and the one in the housing market five years ago mean that bubbles and possible bubbles are on people's minds these days. The media writes about them a lot, policymakers think about them a lot, and it's natural for people to worry about them in their personal decision-making, too.

But before you get too invested in this, note that bubbles are really hard to spot. Even the really obvious bubbles. Take, for example, the case of the housing bubble, which Paul Krugman calls "the most obvious thing I've ever seen."

It’s true that [Alan] Greenspan and others were busy denying the very possibility of a housing bubble. And it’s also true that anyone suggesting that such a bubble existed was attacked furiously — "You’re only saying that because you hate Bush!" Still, there were a number of economic analysts making the case for a massive bubble. Here’s Dean Baker in 2002. Bill McBride (Calculated Risk) was on the case early and very effectively. I keyed off Baker and McBride, arguing for a bubble in 2004 and making my big statement about the analytics in 2005, that is, if anything a bit earlier than most of the events in the film. I’m still fairly proud of that piece, by the way, because I think I got it very right by emphasizing the importance of breaking apart regional trends.

Now here's the problem.

Baker did indeed call the bubble in 2002. And from the standpoint of, say, 2012 he looks prescient. Prices kept going up for a while after he made his call, but they eventually crashed to well below 2002 levels in inflation-adjusted terms. Another prescient thing Baker did was tell the Wall Street Journal in 2010 that despite the fall in prices, houses were still overvalued.

FHFA data

But look at what's happened more recently. Home prices are now above 2002 or 2010 levels in inflation-adjusted terms:

FHFA data

Now, obviously there was a real housing bubble. And Baker was attuned to the signs of a bubble — notably a sharp increase in the ratio of the price of buying a house to the price of renting one. But from where we sit in 2015, that actually makes him look too prescient. Neither prices nor that key ratio have ever come all the way back down to 20th-century levels, in part because we seem to be seeing a zoning-induced structural divergence in the price of buying a house from the price of building one.

Just to make sure this isn't all about picking on Baker, I took a serious look at buying a condo in DC back in 2006, only to reject the idea as I read more about the national housing situation. It started to look clear to me that we were in the midst of a historic housing bubble. And by 2006, we really were! But DC realtors tried to explain to me that real estate is an inherently local thing, and it's the local market that mattered, not the national one. That sure seemed like self-serving BS to me, so I dismissed them.

But in this case, the self-serving BS was totally correct. Check out DC-specific house prices:

It turns out that 2006 was a perfectly fine time to buy. The nationwide collapse in house prices barely touched the district, and prices have soared to way above their 2006 levels.

All of which is to say that financial market bubbles are definitely something that happens, and they are definitely important. But they are hard to spot. Not just because sometimes there's a bubble you don't realize it, but because even when you actually do spot very real bubbles, nailing down the timing and specifics is incredibly challenging. If you work full time as a professional analyzing financial markets, maybe you can make money trying to time investments around bubble spotting. But as an amateur, it's probably not worth your time to try.

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