Posted by: Daryl & Wendy Ashby | October 6, 2010

The ‘Greater Fool Theory’

As has been mentioned before in previous posts, a surprising number of Canadians assume that they are not as reckless as Americans when it comes to piling on debt. The numbers seem to be showing otherwise. Part of the reason for this debt is that incomes in Canada have been stagnating relative to rising mortgage and credit card debt.

Some of the best work produced in a long while with respect to looking at real estate prices in Canada comes from Alexandre Pestov published at the Schulich School of Business. Petrov’s analysis led him to conclude that the affordability levels in major Canadian cities – led by Vancouver – are worse than in the twenty largest metropolitan areas in the US during their boom.

In Vancouver, there seems to be a prevailing logic that “Vancouver is unique therefore prices are justified?” People in Miami or San Diego probably felt the same way a few years ago.

What makes a city unique is income, employment prospects and livability. At the elevated valuations we are seeing currently, it would appear that for prices to continue higher, Canadian real estate prices – led by Vancouver – will have to demonstrate the “Greater Fool Theory” – where sky high prices fueled by record amounts of debt can only continue if there is someone else willing to take on even more debt and pay even higher prices. This sounds like a recipe for trouble.

As James Chanos, the renowned hedge fund manager who is shorting Chinese stocks – said in a recent television interview – it is not high prices that mark the existence of a bubble but rather high levels of debt punctuated with a lack of rational behavior. In his words, China is “on the treadmill to hell”.

Likewise, for Vancouver or other Canadian cities, it cannot be said that there is a real estate bubble just because prices have run up. That logic is linear and simplistic.That is too easy a hurdle to earn the bubble label. Rather, it is the herd mentality and the belief that somehow “this time is different.” Those four words are often said to be dangerous to one’s financial well being

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