Stock prices increased substantially in Q3 2016. Prices remain unsustainably high and this bubble is likely to burst in the coming months. Tumultuous global markets have caused investors to act cautiously, which has contributed to the volatility seen in recent months. However, increased uncertainty abroad has also led investors to see the U.S. as the safest bet available.

Home prices also remained high in Q3 2016, but began to decelerate by quarter’s end. They are expected to trend downward following the steep rise in mortgage rates which began in November 2016. Anticipate home prices to decline slightly in 2017, to reverse direction in 2018 in response to a boost from the recovering economy and changing demographics.

Real estate is a solid investment, but only for long-term purposes due to the high cost of acquisition and upkeep. Forecasters are in agreement on what is going to happen to the stock market and real estate in the next couple of years, as both are currently supported by unsustainable momentum and a “fear of missing out” on ever more profits.

Stock market investors need to consider moving their wealth into the real estate market before the stock market bursts, likely on the eventual withdrawal from U.S. dollar-denominated investments as the global recession ends and investment opportunities arise elsewhere in the world.

Updated 12/09/2016. Original copy released 05/27/2015. 

Chart update 12/09/16

Q3 2016 Q3 2015 Annual change
Home price index 237.7 227.4 +4.5%
Stock price index 1989=100
735.3
651.1
+12.9%

Stocks: the volatile choice

The chart above displays two indices:

These indices track price movement (not actual prices). The stock price index in Q2 2016 reflects a gain of about 1.7% over a year earlier, while California home prices have increased 5.2% in the same time period.

Home prices rise and fall in a generally smooth fashion, as seen in the chart above. Stock prices, on the other hand, display more volatile movements. 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) to close a home sale, while stocks can be traded – both bought and sold (and the reverse) – in an instant.

Thus, stocks have a tendency to move on momentum (gained or lost) much more quickly than home prices. They too frequently are bought on rumor, sold on facts. Today, stock prices are at an unprecedented high – and expected to fall.

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. 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 but a savings account. There they sit, and gradually waste away with no earnings. Terrifying if you are very rich.

Stock prices: a history of speculation and downfall

From 1950 until the 1980s (a period of rising interest rates) stock prices mostly bumped along at a gradual upward clip. Stocks picked up steam in the 1980s, then, the mid-1990s saw stocks begin to rise more quickly as interest rates declined toward zero. The upward price slope became a steep incline, culminating in the dot-com bubble, which peaked in March 2000 as the Federal Reserve raised interest rates to send the country into a routine business recession.

Stock bubbles occur when speculators essentially overvalue a stock, displaying a lack of concern for investment fundamentals. A long-term investor purchases stock they perceive is currently undervalued, in the anticipation it will grow to reach its full value in the future. However, speculators only purchase stocks when their prices are swinging upward, further inflating the already overvalued stock by this momentum buying.

In the case of the dot-com bubble, speculators bought up any and all stock having to do with the internet. This activity vastly inflated dot-com stocks, evidenced by the fact that many internet companies had large customer bases, but typically operated at a loss as they burned through capital reserves (i.e. Amazon at the time).

The dot-com bubble burst in 2000, made worse by the nation’s 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. However, the stock market recovered in 2009 with the advent of zero-cost money, and is still up, though slightly unstable, as of March 2016 for the same reason.

The current commodities bubble isn’t due entirely to speculation. It started off as a reaction to a world-wide increase in the prices of commodities like oil, food and metals, largely due to the rise in voracious emerging markets. In recent years, speculators from all around the world have poured into the stock market, inflating it to unsustainable heights.

Real estate: the choice for greater stability

Real estate prices experience bubbles, too. They’re just not usually as explosive (save the Millennium Boom experience).

Compared to stock investors, who can lose a fortune in a single day, real estate investors have longer to adjust to changes in property prices, minimizing their losses if they must liquidate. Further, while real estate bubbles can be problematic for short-term investors, they have much less influence on long-term investors of real estate. That’s because property prices are drawn toward the mean price trendline, which reflects the gradual upward movement of consumer inflation over the years. Stocks are not tied to labor, materials or ground, the prices of which are tied to personal income and population growth.

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 similar to home prices.

The Millennium Boom was the most recent example of a vastly overblown real estate market, fueled by deceptively easy money and 30 years of building consumer expectations of ever-rising prices (the reciprocal of declining interest rates). More recently, real estate speculators blew a lot of hot air into the housing market in 2012-2014. This caused home prices to rise and home sales volume to drop.

In 2016, speculators have diminished considerably. However, their influence lingers as home prices remain well above their place on the mean price trendline.

Real estate – at least it keeps up with inflation!

Homeownership is an easy investment choice for mom-and-pop investors. That’s because real estate as a store of wealth is a hedge against inflation. Even savings accounts don’t keep up with inflation – though they are probably the safest place to park your money.

Of course, stock prices have increased more rapidly than home prices in recent years, making stocks a more profitable investment – if you sell at the right time. However, given the casino-like instability of stock market investments, real estate is preferred by the long-term investor for being both:

  • less risky than the stock market; and
  • more profitable than bonds or a savings account.

However, there are some extra costs and duties that come with real estate investment, including managing rental income to cover carrying costs and expenses like:

  • maintenance;
  • property taxes;
  • locating tenants if the ownership is of a rental or commercial property;
  • acquisition costs; and
  • the high cost of selling.

Another benefit of property investment is the predictability of rents.

Rents track income; prices of stocks and real estate react to interest rate changes. Rents for all types of property are tied to incomes, be they personal income or business income. Everyone and every business needs to be sheltered, and it is their income that allows them to pay rent for that space.

Therefore, real estate investors are best served by making a commitment of several years. Property (located where population density and incomes don’t decline) increases in value as incomes (individual and rental) move upward with consumer inflation. Further, if the population rises and the increase in incomes is greater than the rate of inflation, property prices move beyond the rate of inflation, called property appreciation.

While rental income provides an annual rate of return on invested wealth, the wealth in the property is itself recovered on resale – including price inflation and appreciation in value. The same cannot be said of stocks, whose value is fleeting and intangible.