The Co-Integration Theory Between Real Estate and the Stock Market
The era of zero interest rates in our world has allowed hedge funds to borrow capital at lower interest rates to invest in real estate and the stock market. This has led to large asset price bubbles increasing at unprecedented rates. With excess liquidity and capped inflation, real estate and stock prices continue to rise.
It was the International Monetary Fund (IMF) that sounded the alarm with a sharp correction of the Toronto housing market. This also led Moody’s Investor Services, a financial services company, to downgrade the credit rating of Canadian banks.
However, I was particularly intrigued by a longtime customer who wanted to purchase a $900 hockey skate for his son. Unfortunately, this longtime customer notified me that he declared bankruptcy with respect to his businesses as his family began to overstretch their consumption patterns. Adding to this, a new house and a new car definitely contributed to his personal financial demise.
Since I was fitting the kid with his new skates, he seemed oblivious to his father’s debt and economic woes. The father also blamed his financial distress on his choice to listen to an unqualified broker who persuaded him to refinance his mortgage and inject that capital into the stock market. Subsequently every time his purchased stock declined, he would sell his shares and consecutively lose larger sums of his investment.
I told his father outright that he should never allow things to sputter out of control at the expense of another man’s opinion. He turned and glanced at his son, “Thank God mom works like a dog.” Again, his son seemed oblivious as he admired the new skates on his feet.
In my mind I knew very well that the father was a major contributor to the family’s financial distress. It seemed that these parents overinvested in their teenager’s world and performance as an overrated hockey player. In my view it’s vitally important for an adolescent to view and experience reality even if their parents aren’t in control of their life.
The father motioned me to the side and asked me if I was willing to take installments for the brand new skates. I was quite frank and told him that I wouldn’t be able to do that, so I offered to reduce the MSRP of the skate so I could make a few bucks and so that his son would be able to walk out of the store with his beloved new skates.
The deal was done, but the father got me thinking whether or not Torontonians are leveraging their real estate assets and lines of credit to get into the stock market. I assumed this was because most people were simply interested in making a quick dollar rather than focusing on long-term investment.
In a mature and overvalued equity market, there will be imprints of herding that promote speculation often characterized by real estate prices becoming highly volatile and unsustainable. Excess liquidity generates a wave of optimism underpinned by favorable developments and real estate corresponding to a fictional capital gain. This fictional capital gain undermines capital risk in the equity market and only contributes to inflation of asset bubbles in both real estate and equities.
If an increase in the stock market makes people wealthier then these people will subconsciously consume more. If a market correction occurs, then it adversely affects investors’ future spending habits. With prolonged stagnant wages, real estate wealth accumulation may be deployed as a future anticipatory wealth growth in consumption. Therefore the aggregate wealth of a household may reflect an overwhelming importance to a substantial gain and a substantial loss in the stock market.
Due to the low interest rate environment, the pace of wealth accumulation will not materialize through savings. Therefore putting money in the bank as storage will no longer provide the necessary yield investors expect thanks to the irrational expectations a low interest rate world has given them.
When you see others advance in life and begin to purchase $100,000 cars and $1,000,000 houses, then the natural inclination is to mimic them. The expectation is to be part of the group, especially in the hockey milieu that every kid adheres to. This particular kid’s expectations were reasonable because he never had anything else to compare it to.
Maybe the Dow Theory has changed. Perhaps the Dow transportation won’t be the trigger to deflate an equity bubble. If housing wealth is related to household consumption, it could also influence the confidence in the stock market. If stock returns have a significant relationship with rising real estate prices, then any stock bubble should also reflect unsustainable real estate bubbles.
The only way that this sequence could happen is if the movement of the real estate market moves towards the stock market in a prolonged and slow fashion while liquidity co-integrates into the financial risks that rise in tandem with the equity market.
The subprime debacle had a devastating effect not only to real estate, but to the financial ecosystem that allowed stock prices to accelerate with real estate prices. This allowed a false appraisal of property valuations that became problematic with relaxed liquidity provisions. The perception of large capital gains from real estate is to achieve higher yields by redirecting the influx of funds from the housing market to the stock market.
This phenomenon will allow structural herding to play out not only as a process of human behavior, but also as a process that increases the magnitude of future asset price bubbles to a point where they truly become uncontrollable.
When asked about a possible financial crisis, Janet Yellen indicated, “You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.”
Unfortunately she has failed to understand the human transmission process. The Toronto housing market claimed a $1 million price tag a few months ago, now the market claims a $750,000 price target. Who’s to say it can’t go lower?
The kid left the store happy. Who wouldn’t? It’s hard to return a pair of $900 skates once you try them on. Was the dad happy? Perhaps, after all, his wife is working like a dog.
I'd like to thank Michael Ambrozewicz for his contributions to this article.