Driving in a Bubble

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We have lived through our share of bubbles in the economy. Just within the last 20 years, we have seen a major stock bubble and a major housing bubble.

You could say that we have been in multiple stock bubbles since the 1990s, but the tech bubble of the late 90s was the worst. You could argue that there is a stock bubble now too.

If you go back to the late 1970s, there was a bubble in precious metals, with double-digit price inflation encouraging people to buy hard assets.

Even many so-called mainstream economists will now admit that the Federal Reserve is a factor in driving these bubbles. When you have easy money flowing, along with artificially low interest rates, the new money does not initially spread out equally into the economy. It flows into certain hotspots. Wherever this money flows, prices will rise and a bubble will form.

When a bubble bursts, it is usually associated with a recession. A recession is really a correction of the misallocated resources. It is actually a necessary process, although a painful one. The initial misallocation was not necessary, but the correction is necessary to realign resources.

Think about the housing bubble of the mid-2000s. With loose money from the Fed, along with government policies that encouraged home ownership, especially with low interest and low down payment loans, money went into housing. Prices were bid up to astronomical and unsustainable levels.

Some places were worse than others, but it was mostly a nationwide housing bubble. Once the bubble burst, we saw the high unemployment and the exposure of all of the bad loans. Still, once the housing bubble was blown up so much, a correction was necessary to bring prices back down and to realign resources.

It was obviously painful for a lot of people, especially those in the real estate sector who suffered job losses or significant pay decreases. But the correction was necessary because it was a massive waste of resources to have so many people employed in the real estate sector, whether it was builders, or agents, or loan officers. It was also a waste of raw materials used to build the excess supply of houses.

It is easy to see the correlation of the bursting housing bubble and the big economic fall of 2008.

But not every popping bubble has to be associated with a recession. Take oil as a recent example. There was a bubble in oil with loose money and low interest rates. There was massive investment in shale oil in the U.S., much of which probably would not have taken place if the investors had known that the price of oil was going to go down to around $30 per barrel.

Either way, the price of oil is way down from its previous highs and it has not been associated with a recession. We may or may not get a recession in the near future, but oil prices were tanking in 2014. It has hurt some of the investors and workers in that sector, but it has not been felt across the United States. In fact, it has been mostly positive for consumers, with cheaper prices at the pump.

Another Unexpected Bubble

We don’t always know that a certain sector is in a bubble. If everyone knew, then the bubble would already be over.

If you look back at housing around 2006, there were certainly some people saying it was a bubble, or at least cautious about it. But there were some who thought that housing would never go down.

At that point, it didn’t really matter what anyone thought. The housing prices were going to come down because some people simply couldn’t afford to make the payments on the houses they bought.

Some would argue today that we are in a housing bubble. This is debatable. Housing prices have certainly gone up in many areas over the last five years. But many places have not come close to reaching the highs that were seen back around 2007.

It seems to be more regional this time. If we are talking about San Francisco, where the median home price is well over $1 million, then that can probably be safely labeled as a bubble. In fact, one small homebuilder just announced this week that it was not going to build any more homes in San Francisco because of the inflated house prices.

Aside from housing, there are other possible bubbles that exist right now. Stocks, which have been dependent on loose money from the Fed, have certainly scared people in 2016. But even if we know that it is a bubble, we still wouldn’t know when the bust is going to take place.

There is probably a bond bubble too with interest rates so low. But rates could still go lower. There will likely be a time when interest rates spike and bondholders get smashed, but we could be years away from that.

There is one bubble out there that may be right under people’s noses without them realizing it. It has been getting a little bit of attention, but probably isn’t thought about much.

It is a bubble in automobiles. In particular, it is a bubble in the auto loans used to purchase cars and other vehicles.

The average price of a new vehicle in the United States is now more than $33,000. For Americans, this is the new normal. They don’t remember a time when people could buy a new car for under $10,000.

Some of this increase can be attributed to the costs of actually building vehicles. There are a lot of government mandates in terms of safety and efficiency that the car companies have to abide by. Still, the consumers are paying these prices for new vehicles, and often paying more for luxury than what they need.

Buying Transportation or Buying Luxury?

We now live in a country dominated by SUVs, extended-cab trucks, and luxury cars. I understand the desires. It is nice to have an SUV when you have kids and strollers to drive around. For truck owners, sometimes it really is necessary as part of their work.

Still, many people pay far more for their vehicles than what is necessary. There is nothing wrong with this except that many simply cannot afford it. It is like the housing bubble all over again. Except with a house, at least you have a chance for appreciation. With a new car, you are almost guaranteed to get a quickly depreciating asset.

The cash for clunkers boondoggle took place in 2009, where the government encouraged people to turn in their old cars to buy new and get government money. The government managed to destroy hundreds of thousands of vehicles that worked perfectly fine.

This actually had the effect of making used cars more expensive, which actually hurt poorer people the most.

Still, there are plenty of good used cars out there now. And believe it or not, you can still buy a new car for less than $20,000 with many technologies that did not exist a few years back.

But we are back to the story of easy money and low interest rates. In order to afford the $35,000 SUV, many Americans are now taking out car loans for six years, or sometimes even seven or more.

There is nothing wrong with owning luxury items. And many people can afford owning a really nice vehicle. The problem is that the median American household income is about $54,000. When you factor in taxes, some Americans are working nearly an entire year just to buy their transportation, or maybe more if the family has two new cars.

And just as we saw in mortgages, there are subprime car loans. According to a recent report, almost 5% of subprime auto loans that were sold to investors (similar to mortgage-backed securities) are delinquent. And now over 20% of loans are for consumers considered to be subprime, with expectations that defaults will climb higher. Overall, it is not a pretty picture.

The Crash

The American middle class is struggling. Perhaps the people struggling need to take some responsibility in the choices they make, especially when it comes to buying expensive cars they can’t afford.

Still, we are once again in a situation where the government and the Fed have encouraged these easy loans. It isn’t so much the car companies that are tricking people into buying expensive vehicles and taking on loans they can’t afford. It is more an issue of the Fed tricking people into taking cheap money and letting people think they have more savings and wealth at their disposal than they really do.

With the average price for a vehicle now exceeding well over half of the median family income, we can be reasonably sure the situation is unsustainable. The bigger question is how things will play out.

A crash in the auto bubble won’t be as devastating as a crash in the housing market. The numbers are smaller (in dollar terms) and the assets are more liquid. Still, it isn’t a small thing either, and any time a bubble bursts, some people are greatly impacted.

GM and Chrysler were already bailed out in 2008/2009. What will happen if there is a severe crash in the auto market?

People need transportation. But people also need a place to live and that didn’t prevent a housing bust.

Car prices may get a lot cheaper in the future. Some people will just drive their old car longer, opting for repairs over luxury and new.

Perhaps the bigger question is whether the rest of the economy will go with the car market the way it did with the housing bust.

Until next time,

Geoffrey Pike for Wealth Daily