Market heal thyself! - Part 2

In the first part of this post, I showed on a couple graphs the clear bubbles that had formed in the stock market during the late 1990s and in the real estate market in the early part of this decade.

There are two main questions that this second post hopes to answer: (1) Why the bubble? (2) What should be done about them?

The answer to the first question is easy. In both cases, it was greedy speculation that drove stock values up higher than they ought to have been. Do you remember the hype in the late '90s about the "new economy" where silly and arcane things like fundamentals (ha!) didn't matter anymore? Do you remember the people who poked fun at that old (billionaire) fuddy-duddy Warren Buffet when he cautioned that those antiquated fundamentals didn't support such a astronomical valuation in the market?

I remember making thousands of dollars in a single trade. I owned one stock that went up 50% in one day, then another 35% the next. It was crazy! You could be a total idiot and make money in the stock market for a year or two there. And that's just what happened...the idiots got into the stock market, thinking that there was nothing to it. They just had to jump on board and enjoy the rising tide. I know people who invested thousands in Enron when it plummeted to penny-stock values.

All that speculation just put more pressure on the bubble until the inevitable.

The same thing started happening in real estate around the same time that the tech stock bubble burst. When the enforcement of the Community Reinvestment Act started forcing bankers and lenders to invent creative ways to finance the home purchases of folks who couldn't afford, or qualify for, a conventional (safe) loan, more people started buying homes. When Fannie Mae and Freddie Mac began purchasing securities and bonds backed by these weak mortgages, more and more lenders got comfortable underwriting the riskier loans. The secondary market for these bonds just fueled the home purchases. The flood of purchases raised the median value of homes in the U.S.

Now, people saw another chance to profit, another wave to ride (and another way to speculate). Middle class folks began buying vacation homes, lake homes, beach homes, rental homes. They started buying homes that hadn't been built yet just to turn around and sell the unbuilt home for a 25% profit! Folks who wanted a home began to see their dream slipping away as prices soared almost out of their reach. So they jumped into a bidding war and paid $800,000 for a house that had been put on the market for just $600,000, just so they wouldn't lose the chance to own a piece of the pie.

All that speculation just put more pressure on the bubble until the inevitable.

In both cases, the stock market, and the real estate market, the inevitable happened, as inevitables often do. The bubble burst.

Now the second question: What to do? This one is easy, but I'm going to have to turn up the volume to make sure you can hear...

ABSOLUTELY NOTHING!!!

In case you missed the bold headline today, "U.S Existing Home Sales Rise on Record Price Slump." Wait, what? I thought we needed the government to come in and prop up home values for us? You mean that when prices fall far enough (in this case, 15% in the past year) for them to become attractive to buyers, buyers will come out again?

That's right...supply and demand. It works in the stock market and in the real estate market. In the stock market, we are seeing companies whose fundamentals cannot possibly support their lofty valuations going out of business left and right, whose fundamentals were compromised by risky business decisions and blind greed. As company value falls to meet the trendline of supportable growth, so does the stock price. Companies and stock value are wiped out in the process. Pruned, to make room for healthier growth.

Real estate cannot simply go away, so values just drop until that supportable trendline is met, where buyer and seller can be happy, so to speak. Home values are cut down to support healthy, supportable growth.

The markets (especially the housing market) don't need any "help" from central government. If home prices are artificially supported at bubble levels, the inevitable will still occur...it will just be postponed. If sick businesses are propped up through cash infusions from the government, the inevitable is again delayed. Worse, the bad is sustained artificially choking out the new growth through normal competition.

It's time for a bit of a swing back in the direction of laissez-faire policies. Not at the sacrifice of smart regulation, but to save us from ourselves.