Sunday, March 13, 2005

Jeffrey R. Scharf: Everybody’s Business

Jeffrey R Scharf, Santa Cruz Sentinel

It has been five long years since the stock market bubble burst in the spring of 2000. The NASDAQ Composite Index, which epitomized the era, set an all-time closing high of 5,048 on March 10, 2000. Last week, the NASDAQ was mired nearly 60 percent below its peak.

The bubble was characterized by a mass hysteria that seems unfathomable today. The NASDAQ soared 86 percent in 1999. Companies that were losing money exhibited the best price performance. Brokerage analysts, much of the financial media and many investors created new metrics to justify the unjustifiable. Traditional yardsticks like sales, profits and dividends meant nothing. Success in the "new economy" was measured in eyeballs, page views and first mover advantage.

Television ads portrayed online trading as the road to riches. One commercial featured a tow truck driver who bought his own private island. In real life, The Wall Street Journal ran a front-page story about 20-somethings in their first jobs with greater net worth than their doctor, lawyer or executive parents. The Journal also ran a series featuring a Pennsylvania barber who dispensed stock tips along with Barbasol. At one point, his portfolio was valued at $800,000. Unfortunately, the bubble burst before he reached his retirement goal of $1 million.

Yes, there were warnings — some of them right here in this column. Those who did warn were told they "just didn’t get it." Even Warren Buffet, who was voted the best investor of the 20th century, was considered a has-been as Y2K dawned. At times, it seemed that those who knew the least prospered the most.

While stock market investors may or may not have learned their lesson, one does not have to look very far to see another bubble right before our eyes. Real estate in 20 percent of the country — including much of California — is experiencing house price inflation untethered to traditional metrics.

Richard DeKaser, chief economist at National City, studied median housing prices in 99 metropolitan service areas from 1980-2004. DeKaser compared median incomes to the cost of servicing a traditional 20 percent down, 80 percent borrowed, 30- year, fixed-rate mortgage on the median-priced home. Each MSA was evaluated separately to reflect the fact that houses in San Francisco are always more expensive than houses in, say, Phoenix.

According to DeKaser, the seven most overvalued markets in America are Chico, Stockton, Santa Barbara, Los Angeles, San Francisco, Modesto and San Diego. Overvaluation in each area is more than 25 percent. Assuming Santa Cruz — which was not included in the study — is equally overvalued, the median price here should be closer to $500,000 than $700,000.

Like the true believers in NASDAQ, true believers in real estate are eschewing traditional analysis. Instead, we hear that prices never go down, the area is too desirable, the demograhics are positive, yada yada yada. More likely, the price frenzy is being driven by rampant speculation — the National Association of Realtors estimates 23 percent of houses last year were sold to "investors" — and easy money. These investors include buyers who put deposits on houses in new developments and "flip" the property for a profit before the house is even built. Meanwhile, buyers are lured into the market with loans whose terms may include either 0 percent down or 0 percent initial interest. Credit can’t get any easier unless lenders start paying people to buy houses.

How large will the real estate bubble grow and when will it burst? That is as unpredictable today as predicting when the NASDAQ bubble would burst. However, anyone who owns investment real estate in an overvalued geography or is counting on their primary residence for more than shelter would do well to consider the words of legendary financier Bernard Baruch. When asked about the secret of his success, Baruch replied, "I made my money by selling too soon."

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