When markets run out of greater fools

The ‘greater fool theory’ states that it is possible to make money by buying investments, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who will be willing to pay a higher price.

When a type of investment does very well for a long time, it attracts investors. Many feel they’re missing out on something good. We believe that such is the case in Canada’s two hottest housing markets: Vancouver and Toronto. Bidding wars show that some are willing to pay high prices to buy a house.

We think that houses have become too popular. Speculation in any type of asset, including houses, usually ends badly. Experienced investors will recall market corrections, or worse (revisit 1989), when house prices fell in both cities.

Both cities have some things going for them. The populations of Vancouver and Toronto keep growing. For instance, it’s estimated that the Greater Toronto Area grows by ‘a Kingston a year’. That’s over 120,000 people. This supports the housing market.

On the other hand, the tight supply and high prices have driven some residents to relocate to more affordable communities. Even if prices stop escalating, relocation could intensify in the future.

The low loonie attracted footloose capital

Foreign investors have found Canadian houses affordable. Especially with the lower loonie. But this is now less true in Vancouver. One study found that Vancouver has displaced London, England, as the world’s most at-risk housing market. Still, the B.C. government put a 15 per cent tax on foreign buyers.

A third factor driving up house prices is historically-low interest rates. This makes servicing even very high mortgages doable. We expect interest rates to remain quiescent. Particularly with ‘negative’ interest rates prevailing in Europe and Japan.

Few younger buyers expect to have to repay million-dollar mortgages. Particularly if they subscribe to the ‘greater fool theory’.

The greater fool theory

When the price of an investment rises for a long time, it eventually becomes overpriced. Nevertheless, some people are willing to buy. They acknowledge that they’re a ‘fool’ to pay such an inflated price for the asset. The thing is, they expect an even ‘greater fool’ to take it off their hands at an even higher price.

This likely explains why some younger home-buyers are willing to take on million-dollar mortgages. They think they can sell if they need to—in order to build a RRSP (Registered Retirement Savings Plan), a TFSA (Tax-Free Savings Account) or even just to take a vacation, occasionally eat out, or buy new clothes.

But when house prices stop rising and start to fall, however, the supply of greater fools will dry up in a hurry.

Hundreds of thousands of boomers are gradually retiring. Some lack pensions or have inadequate pensions. They hope to sell their houses at today’s prices and live happily ever after. Others, whose children have left, will need less space. They may not want to maintain a big house. Still others will develop infirmities that require them to live in single-level housing or retirement residences. When they start selling in droves, prices will drop.

To whom do boomers expect to sell to? Millennials working in precarious jobs saddled with student debt and car loans? When prices start to fall, the supply of ‘greater fools’ will dry up.

 

The Investment Reporter, MPL Communications Inc.
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