gold investment, silver investment

Precious metals investment terms A to Z

Housing Bubble

You should buy a house. After all, the real estate cannot lose value. This was the common belief that led to the Great Recession. It all began in the aftermath of the dot-com bubble. When the Nasdaq, Dow Jones and S&P 500 Index plunged, people got discouraged to the stock market and they fled to real estate. Even Mark Twain once said: “Buy land, they aren't making anymore of it.” Real estate was considered to be safe. But it was an illusion. A bubble.

The housing bubble is a special kind of a price bubble (also referred to as a speculative bubble, economic bubble, asset bubble or financial bubble). The latter is an upward price movement over an extended time period which then implodes. So, the housing bubble occurs when the real estate prices deviate upwardly from their fundamental value. However, the deviation cannot last forever – and after some time, house prices fall significantly to adjust to the fundamentals.

Although the basic mechanism of a housing bubble is the same as for other asset bubbles, its effects for the real economy are particularly severe. This is because the bursting of the housing bubble affects negatively the balance sheets of the household sector. The bubble is credit-fueled, so its burst leads to debt overhang among the consumers. As they focus on repaying the mortgages, they do not take new loans, which leads to the slow recovery. 

Mid-2000 U.S. Housing Bubble

The history records many housing bubbles. But the best known example is the mid-2000 U.S. housing bubble. It was caused by the easy Fed’s monetary policy adopted in response to the dot-com bubble and the September 11 attacks. Low interest rates and lax credit conditions spurred speculation and demand for houses. Moreover, the U.S. politicians were beating the drum of the American Dream and pressured banks and other financial institutions to grant loans even to subprime borrowers. Mortgage loan securitization also contributed to the boom. After all, the banks could get away with passing loans to anyone with a pulse, stamp that tripple A and offload the risk to someone else’s balance sheet via collateralized debt obligations. Hands up who remembers robo-signing!

But every party ends one day. In February 2007, the S&P/Case-Shiller US National Home Price Index reached its peak, increasing more than 84 percent since January 2000. Then, it has been declining until early 2012, as one can see in the chart below.

Chart 1: Gold prices (left axis, yellow line, London P.M. Fix, $, monthly average) and the US housing prices (right axis, red line, S&P/Case-Shiller U.S. National Home Price Index, Index Jan 2000=100, Monthly, Seasonally Adjusted) from January 1987 to December 2018.

Housing Bubble and Gold Chart

Housing Bubble and Gold

What is the link between the mid-2000 U.S. housing bubble and gold? Let’s look at the chart above again, which compares the index of US housing price and the gold prices. As one can see, they moved in tandem in the mid-2000s, but when the housing bubble burst, the price of gold accelerated even further toward the north. And when the house prices bottomed, the price of gold peaked. Then, the housing index started its recovery, while the gold entered the bear market in gold. Hence, there is no clear relationship between the gold and house prices. They rose together in the mid-2000s only because the interest rates were low. When the housing bubble burst and cascaded through the financial system, the world fell into economic crisis, which added fuel to the fire under gold. But when the US housing market and the global economy recovered, the gold fell out of favor. 

That Was the Housing Bubble. Can There Be a Gold Bubble Too?

That was the most recent housing bubble. They say every dog has its day. Can the same be said about all asset classes? In other words, can there be a bubble in gold as well? Certainly, and we have a not-too-distant example to prove that. We have already covered stagflation of the 1970s and the easy monetary policy of that era, courtesy of the Fed Chair Arthur Burns. Understandably, people have been faced with waning purchasing power of the U.S. dollar, with higher inflation rates. And they were looking for a hedge.

This was the time of Nixon closing the international gold window in August 1971. The last remaining link of U.S. dollar to gold had been broken and gold was floating in terms of the U.S. dollar ever since. Once it became legal again for U.S. citizens to own gold in 1974, they flocked to the time-tested inflation hedge in droves. For a while, they had a rough time as gold topped at $200 in early 1975 and went on to correct to $100 in mid-1976. A 50% correction. Rising from the ashes, egged on by galloping inflation, a speculative frenzy followed. It has driven gold to well over $750 in January 1980. It’s hard to forget those iconic queues at your local gold coin dealer’s!

This was the time of lost confidence in the fiat currencies. It took drastic action to restore it. It took Paul Volcker to stop the bleeding. It took draconian interest rate hikes to do so – the Fed funds rate went from 11% at the time of his taking office in August 1979 to a peak of 20% in June 1981. For the first time in quite a while, bonds stopped being derisively called certificates of guaranteed confiscation and the era of positive real interest rates started. With it, the bond bull market was born. And it meant the end of gold’s bull run that finished with the above-mentioned blow-off top. Gold entered a bear market and the rest is history, as they say.

Can such a gold bubble happen again? Certainly, it can – once the right set of circumstances arises. We’re not there yet, however. Some may view gold’s parabolic top of September 2011 as the bubble that burst, but it seems that the fundamentals remain positive for gold and that it can move even higher in the following years. Gold’s golden years likely still lie ahead of us. And fortunes will be made. Again.

We hope you enjoyed the above definition. We encourage you to learn more about the gold market – not only about the link between the housing bubble and gold, but also how to successfully use gold as an investment and how to profitably trade it. Great way to start is to sign up for our Gold & Silver Trading Alerts. If you’re not ready to subscribe yet and are not on our gold mailing list yet, we urge you to sign up. It’s free and if you don’t like it, you can easily unsubscribe. Sign up today!

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