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Bubble Trouble: Your Home Has a P/E Ratio Too
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Excerpt from the Article "Bubble Trouble" in the June 2002 edition of the UCLA Anderson Forecast Quarterly Forecast Journal
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By Edward Leamer
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There is no housing shortage and don’t expect a phantom shortage to prevent a bubble from being created.
I remember a realtor telling me some time ago that I should buy ocean front property because that was
limited in supply and the price could only go up. The same kind of thinking has led many to conclude
that, since California “needs” more housing, the current run-up in prices is justified by supply and
demand, and there is no bubble here. For example, the Los Angeles Times, Monday, May 27, 2002, reported:
“With limited inventory and tightly controlled lending for new projects, the industry runs ‘no risk of
collapse’ even if the economy stumbles, Economy.com analyst Steven Cochrane wrote in a recent report on
the state.”
Both these thoughts reflect a lack of understanding of how asset prices get determined. They reveal
indifference to the behavior of rents, and/or they show a lack of understanding of the connection between
the rents and the asset prices. This is the same error that Wall Street analysts made during the Internet
Rush when they imagined that the New Economy changed the rules and created a fundamental disconnect between
corporate earnings and stock prices. We know differently now. The markets are rudely reminding us that
when we buy a stock (an asset), we are buying an earnings stream. The price we pay for the stock should
reflect current corporate earnings and reasonable expectations about what the future of earnings might be.
A bubble is created when these get disconnected.
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