Stock prices advanced significantly in Q2 2017. Prices, for now, remain unsustainably high, as in a bubble likely to burst at any time without warning. Recent tumultuous global market activities have caused investors to act cautiously, ironically contributing to the current stock market overpricing for present lack of other investment opportunities. Thus, increased uncertainty abroad has led foreign investors to see the U.S. as the safest bet available — including high-dollar homes in major urban areas and passion investments in collectibles.

Home prices also moved higher in Q2 2017, but have been decelerating since the huge jump in 2013. They are expected to trend downward further some 9-12 months after the steep rise in fixed-rate mortgage (FRM) rates that took place in November 2016. Thus, anticipate home prices to end their further ascent during the second half of 2017, and reverse direction in 2018. Eventually in the current business cycle, construction starts are going to have a say in pricing.

Fundamentals suggest real estate today remains a solid investment, but only for long-term purposes due to the high cost of acquisition and upkeep, and the lack of price support in the next recession. Forecasters are in agreement on the direction of the stock market in the next couple of years, since its values are currently supported by unsustainable momentum and a “fear of missing out” on ever more profits.

As for residential real estate, pricing faces an almost certain increase of new construction starts in both single family residences (SFRs) and multiple units. The result will be a dramatic build up in the pace of construction that will outrun the current pent-up demand for housing, generating market-wide surpluses sold only at reduced prices.

Updated August 30, 2017. Original copy released May, 2015.

Chart: Stock prices vs. home prices

Chart update 08/30/17

Q2 2017 Q2 2016 Annual change
Home price index 258.8 241.1 +7.3%
Stock price index 1989=100
821.9
711.8
+15.5%

Stocks: a volatile choice

The chart above displays two indices:

These indices track price movement (not actual prices). The stock price index in Q2 2017 reflects a gain of 15.5% over a year earlier. During the same period, California home prices increased 7.3%.

Home prices rise and fall in a generally smooth fashion, as seen in the chart above. Stock prices, on the other hand, display much more volatile movements within very short time periods. That’s because stock transactions occur more rapidly than home sales due to liquidity differences. It takes a minimum of several days (usually several weeks due to the need for mortgage money and title analysis) to locate a buyer, enter into a purchase agreement and close a home sale. Conversely, stocks are traded – both bought and sold (and the reverse) – in an instant.

Thus, stocks tend to move on momentum (gained or lost) much more quickly than home prices. Further, stocks, unlike real estate, are frequently bought on rumor, sold on facts. Today, stock prices are at an unprecedented high P/E ratio evaluation – and expected to fall.

Overinflated stock prices exist today due to a world-wide dearth of alternative investment opportunities, and massive sums of cheap, short-term money with no place to go beyond a savings account. There they sit, gradually wasting away with no earnings as inflation does its job — terrifying if you are very rich.

However, like home prices, stocks cannot rise indefinitely. When they do fall, expect the drop to be dramatic, reflecting the magnitude of years of build-up.

Stock prices: a history of speculation and downfall

From 1950 until the 1980s (a period of constantly rising interest rates), stock prices mostly bumped along at a gradual upward clip. Stocks picked up steam in the 1980s, rising more quickly from 1990 to the 2010s — a period of interest rate reductions declining to zero and stagnating until 2017. The long-term upward price slope was subject to a steep incline in the mid-1980s, in the dot-com bubble of 2000 and again in the Great Recession of 2008. Each were brought on as the Federal Reserve (the Fed) raised interest rates to send the country into routine business recessions and adjust the economy for excesses — as is taking place in 2017 in the zero lower bound interest rate hangover.

Stock bubbles occur when speculators essentially overvalue a stock, displaying a lack of concern for investment fundamentals. Prudent investors who look forward long-term purchase stock they perceive as currently undervalued based on historical reference, anticipating its price will grow in the future and reach its full value. In contrast, speculators only purchase stocks when their prices are swinging steadily upward, or have completed a sudden and huge drop in pricing. Speculators buying on momentum, not fundamentals, further inflate already overvalued stocks.

In the case of the 2000 dot-com bubble formation, speculators bought up any stock related to the internet. This activity vastly inflated dot-com stocks, evidenced by the many internet companies with large customer bases but typically operating at a loss as they burned through capital reserves (e.g., Amazon at the time; Tesla today).

The dot-com bubble burst was made worse by the nation’s panic response to the September 11, 2001 terrorist attacks. About half of the dot-com companies did not survive the burst.

The next stock bubble occurred in the mid-2000s, called the commodities bubble (or sometimes the commodities super cycle). This bubble imploded in 2008 when the financial crisis hit and the Great Recession emerged. However, in 2009 the stock market recovered due in large part to the advent of zero-cost money for leveraging acquisitions. As of mid-2017, the stock market is still up — though rather unstable — for much the same reason: cheap and easy financing to leverage all purchases.

Real estate: the choice for greater stability

Real estate prices experience bubbles, too. They are just not usually as explosive as stock market bubbles, the difference being the liquidity challenge present in real estate dispositions. An exception is the Millennium Boom, which was due mostly to Wall Street infiltrating the real estate business by becoming its near-exclusive mortgage lender.

Compared to stock investors, who may lose a fortune in a single day, real estate income property investors have a much longer time period for reacting to changes in property sales volume and pricing to and minimizing their losses through liquidation. Further, while enduring a real estate bubble is financially problematic for short-term investors — speculators — bubbles have much less influence on long-term investors of real estate. Their losses are primarily limited to tolerable reductions in rental income when not excessively leveraged.

Historically, income property prices are drawn toward the mean price trendline, a reflection of the gradual upward movement of consumer inflation — and wages — over the years. Unlike stocks, real estate is fundamentally tied to the cost of labor, materials and ground. That said, cyclical real estate prices change in tandem with movement in personal income and population trends — local demographics.

Editor’s note – The chart above displays the average price index of homes sold in three California areas: Los Angeles, San Diego and San Francisco. Other types of real estate (i.e., commercial) are not included, but their pricing runs parallel to home price movements.

The Millennium Boom was the most recent example of a vastly overblown real estate market, fueled by deceptively easy mortgage money — predatory for those who forget — and 30 years of building consumer expectations for ever-rising prices (the reciprocal of the period’s ever-declining interest rates). More recently, real estate speculators blew a lot of hot air into the housing market in 2012-2014 as low-cost cash rolled in. This caused home prices to rise swiftly and home sales volume to drop the following year.

By 2016, speculation diminished considerably, allowing a reservoir of eager buyer-occupants to acquire property. However, the influence of speculators lingered as home prices stubbornly remained well above their place on the mean price trendline, rising at a pace four times the rate of inflation and wage growth. This is the exclusive consequence of the failure of local governments to permit sufficient new residential starts and annually house their growth in population.

Real estate – values run with inflation!

Homeownership is an easy investment choice for mom-and-pop investors. Factually, real estate is a store of wealth that has proven to be a decent hedge against inflation when held long-term. Conversely, federally insured savings accounts don’t keep up with inflation, though they are the safest place to park your money against risk of loss and for instant liquidity in emergencies.

Of course, stock prices have increased more rapidly than home prices in recent years, proving stocks in the short term have been a more profitable investment – when purchased and sold at the right times.

However, given the crap-table-like instability of stock market investments, long-term investors prefer income-producing real estate for being:

  • less volatile and, thus, less risky than the stock market when properly leveraged or free of mortgage debt;
  • more likely to cover inflation and produce a higher annual return (through rental income) than interest received on bonds or a savings account; and
  • a tangible source of increasing wealth and, thus, profit through property price appreciation during ownership due to the demographics of its location.

Yet, operating expenses and costs of ownership come with a real estate investment, involving management of the rental income to cover carrying costs and expenses like:

  • maintenance;
  • property taxes;
  • insurance premiums;
  • locating and moving in tenants;
  • mortgage debt carrying costs;
  • acquisition costs; and
  • the high cost of selling.

Another benefit of an income property investment is the easy predictability of rents.

Rental income receipts change with the local population’s income and density trends, whereas prices of stocks and real estate react to interest rate changes, reflected in capitalization rates. Rents for all types of income property are tied to individual incomes, whether personal or business. Every person and every business needs to be sheltered by real estate improvements. Critically, it is their income that allows them to pay rent to occupy those improvements.

Accordingly, real estate investors are best served by committing to several years of ownership — a decade or two. As incomes (individual and rental) move upward in tandem with consumer inflation, property values increase in locations where population density and incomes are rising. Further, when the population grows and wages increase faster than the rate of inflation, property prices build wealth by moving beyond the rate of inflation, called property appreciation.

Thus, while rental income provides an annual rate of return on a property’s worth, the wealth in the property is itself recovered on resale – including price inflation and appreciation in the property’s value.