PRICE/EARNINGS RATIOS AND PRUDENCE
September 7, 2005
The housing market is in a bubble that will probably end soon. Almost all of the economists saying that the housing market is healthy are the same people who told us that the stock market was not in a bubble back in 1999. Then, they were convinced that economic fundamentals justified sky-high prices for stocks. Today, they are saying that economic fundamentals justify sky-high housing prices, says Bruce Bartlett, a senior fellow with the National Center for Policy Analysis.
However, it is simply implausible to believe that housing starts can continue to grow far faster than the number of households, that prices can continue to rise far faster than incomes, or that interest rates will stay at historically low levels. Eventually, things will return, says Bartlett:
- Just as price/earnings ratios far higher than we ever saw in the past were a sign that the stock market was overvalued in 1999, so too we know that interest rates today are too low and necessarily will rise.
- When the P/E ratio fell, so did stock prices; and when interest rates rise, housing prices will fall.
Homeowners who plan to stay put and have fixed-rate mortgages probably have nothing to fear, says Bartlett. The people who need to be most careful are new homebuyers and investors who have overextended themselves to buy houses more expensive than they can really afford, using interest-only or negative amortization loans. If prices fall even a little, such people will find themselves with negative equity, which could lead to widespread defaults, with ominous implications for the financial system as a whole.
Therefore, prudence should be the order of the day for anyone planning to buy a house, refinance or take out a home equity loan, says Bartlett.
Source: Bruce Bartlett, "Price/Earnings Ratios And Prudence," National Center for Policy Analysis, September 7, 2005.
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