The Australian Canary

Jeremy Grantham is bubble-tracker. The chairman of
investment firm Grantham, Mayo, Van Otterloo (GMO) seems to
enjoy tracking and studying asset bubbles, much like a
biologist might track and tag endangered California

Asset bubbles, however, are hardly an endangered species.
Rare though they may be, several bubbles are currently
frolicking in our midst, according to Grantham. In fact, he
believes, a massive housing bubble is expanding throughout
the English-speaking world at this very moment.

The British bubble is, by far, the most dramatic. But it is
the Aussie bubble, he believes, that deserves the most
attention. "The Australian residential real estate market
could be the canary in the coal mine – that is, a harbinger
of bad things to come for a lot of us," Grantham warns.
"Sydney house prices rose earlier and faster than any
other. Australia also raised its rates earlier and further
than England…And both of these foreign markets have [a
large proportion of] floating rate mortgages, so it would
reasonably be expected that the effect of higher rates
would impact prices faster."

According to Grantham, the Aussie canary is already
swooning a bit. "Sydney prices are well off their highs,"
he observes, "although as yet far from a real bust." But
the "real bust" is certain to arrive, he warns, because ALL
bubbles do "indeed move all the way back to (or below) the
trend that existed prior to those bubbles forming."

Grantham allows no exceptions, simply because he has never
discovered a single exception in any financial market.
Bubbles form; bubble burst; prices revert to the mean –
this is the natural order of the financial universe.

Grantham and his research team have identified "28 good
examples of previous bubbles" from within the world of
global stock markets, currencies and commodities. "I am
patiently waiting for the current 28th bubble, the S&P 500,
to go all the way back to trend – about 750 versus today’s
1150," he says. "It fell to within 10% of trend in 2002,
but still no cigar. But…ALL the other 27 identified
bubbles did indeed move all the way back to [trend]."

Grantham defines a bubble as an asset value that rises more
than two-standard deviations away from its historic trend.
Such "two-sigma events" are the kind that would occur about
once every forty years, on average. Drawing the bubble
boundary at two standard deviations, says Grantham, "seems
(at least to us) to be reasonable, although it is quite

Applying the lessons learned from the financial markets to
the real estate markets, Grantham reveals that inflated
home prices are just as certain to burst as inflated stock
prices, and therefore, just as certain to fall back to the
trends from which they emerged.

The specific trend he finds most useful in assessing real
estate values is the ratio of median home prices to average
household incomes. On this measure, the real estate markets
of Australia and New Zealand are clearly in bubbles, while
the U.K. market is, literally, off the charts.

To illustrate the mean-reverting tendency of real estate
bubbles, Grantham provides the chart below.

"The U.K. housing data…show, in addition to the current
mega bubble, two prior substantial bubbles that both fully
mean-reverted," Grantham points out. "Prices bottomed [in
1995] at 2.9 times income, or another 20% below trend.
Today, though, in the U.K., the price/income ratio would
have to fall by 37% to merely get to trend…Any overrun
would inflict substantial pain…Australia and New Zealand
would be in the same boat as the U.K., but the U.S. would
obviously be less bad."

Nevertheless, "less bed" would still be unpleasant.
Furthermore, he suspects that the pricey real estate
markets on both coasts of the United States could suffer as
badly as the Aussie or U.K. markets. In his hometown of
Boston, for example, the price-to-income ratio is more than
6.5-to-1, which is – you guessed it – more than two
standard deviations above trend.

Here in the Northeast, the white-hot real estate market
might already be starting to cool somewhat. In the fourth
quarter of 2004, Manhattan apartment prices topped $1
million for the third straight quarter. Nevertheless, the
million-dollar average price tag represented a 2.6% drop
from the record prices of the prior quarter.

This week’s new-home sales data also presented some
troubling data about the Northeast property market. When
the Commerce Department announced last Tuesday that
nationwide sales of new homes shot up an astonishing 12.2%
in March, it also disclosed that home sales here in the
Northeast FELL 9%. No doubt the steep falloff in Northeast
home sales contributed to the equally steep 9% drop in
median sales prices last month to $212,300 from $234,000
the prior month. Perhaps the housing market of the
northeastern United States is another canary that bears

"The key point in the U.S.," Grantham emphasizes, "is that
in the recent 3-year stock market decline, all the stock
market wealth lost by the median family holding stocks was
more than offset by a 21% advance in house prices. This
favorable circumstance seems extremely unlikely to recur
[next] time. The inevitable 30% to 40% decline in U.S.
stock prices necessary to get to fair value, accompanied by
flat to down housing prices, will pose substantially
greater risks for consumer spending than last time.

"The ‘best’ reasonably likely outcome in the U.S.," the
bubble-tracker concludes, "is that a moderate stock market
decline in the next two years…could be accompanied by up
to one more year of average house prices rising, for the
U.S. housing market has lagged the other countries and has
some good potential for catch-up in certain regional

"But by this time next year," Grantham warns, "time would
really seem to be running out for our U.S. housing semi-
bubble. It also seems likely that by then the housing
markets in England and Australia will have completely run
out of steam."

Thus spake the bubble-tracker.

Did You Notice…?
By Eric J. Fry

Jeremy Grantham is also forcing himself to consider the
possibility of a bubble in crude oil prices…even though
he hopes not to find one.

Crude oil prices have, indeed, jumped two standard
deviations above their historic trend, Grantham admits,
which technically means that the price jump has reached
bubble proportions. But he wonders whether crude oil might
be that "very rare bird – a paradigm shift." In other
words, he wonders if crude oil might be the first-ever
bubble not to revert to its previous trend. He admits the
odds of such an outcome are very slim.

"Over the years," he explains, "we have asked over 2000
investment professionals [if they knew of] an exception to
our claim that every asset class move of 2 sigma away from
trend had broken [back down to trend]."

Unfortunately, Grantham confesses, "not one of the 2000
ever offered an exception! …But we have always said that
intellectually, you could imagine a paradigm shift in an
asset class price, even if we have been unable to document
one yet in history."

He believes crude oil is capable of resisting the powerful
forces of mean-reversion. "It’s the best possibility I’ve
seen in my career," he says. "But the investment desert is
littered with the bones of those who bet on new paradigms."

[Ed. Note: It makes no difference to Kevin Kerr whether oil
is going up or down, bull or bear, paradigm shift or
not…as long as there’s a market, he still makes money.
That’s because he’s a natural born trader with years of
experience in the pits. With his guidance, anyone can make
money in the energy complex. Here’s what you do…

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