A bubble occurs when there is a sustained rise in price of something beyond what you might believe is its normal value. It occurs when people believe that the price will continue to rise, and so it does rise… until it collapses.
In the early 1700s, the South Sea company was established in London to trade with South America and the Southern Pacific Ocean. One problem was that Britain was at war with Spain at the time, and Spain controlled most of South America, so no trade there then. Nevertheless, the shares went crazy, and then they crashed with many people losing fortunes.
Early Warning Indicators (“EWIs” – also known as Key Risk Indicators or ‘KRIs”) can forewarn of when a bubble might burst. Excessive house prices are a constant concern in a lot of major cities, and the bank UBS produces an annual survey of real estate bubble risk. The survey covers 24 world cities and uses 5 indicators, including price to income ratio, change in mortgage levels to GDP, and price to rental value. It then combines them into a single value that can provide an overall assessment of where house prices are at in a particular city. Combining indicators into a single value involves weighting the component indicators, and it can provide a powerful, single measure to enable you to discuss the likelihood of a risk crystallising.
One of the findings this year is that price to income ratio has risen – overall prices currently reflect 7 years’ income when last year it was only 5 years; so house prices have become less affordable at the overall level. The current hotspots are Munich and Toronto, with the only major city where real estate is deemed to be “undervalued” is Chicago. Meanwhile, London has retreated from “bubble risk” last year, to just “overvalued” in 2019, owing to concerns around Brexit.
Data Sources: Fortune magazine, ubs.com