Having lived and worked in San Francisco during the Tech and Dotcom bubble, I had a first hand glimpse into the bubble mentality and the irrational exuberance of your average consumer. From Dotcom companies throwing lavish parties (while reporting negative earnings) to college students investing their school money in the stock market, to the creation of "short- lived paper millionaires," I easily recognized that this move up in the stock market was not sustainable. In the midst of this bubble, many people would look at their stock options or 401k plans, classify themselves as millionaires, and spend money in the economy that further propelled the rise up in the stock market and further expanded the bubble. The end result was that most of these stock options expired worthless, investors lost millions of dollars in the stock market, and the "paper millionaires" where no longer millionaires.

Throughout history, you will find notable examples of manias, Ponzi schemes, and bubbles that have ended up in disasters with investors cutting back on their spending and scrambling to atone for their financial mistakes. This scenario did not happen after the Dotcom bubble. Instead, investors shrugged off their losses as they saw the value of their homes skyrocket. Consequently, the rise up in real estate prices allowed them to continue spending and temporarily delayed the US economy from heading into a major recession. I believe that 2006 will be the beginning of the burst of the real estate bubble, and that this burst will have immediate and severe consequences on the US economy as a whole.

Your Mortgage Broker Does Not Know Best

As real estate prices have skyrocketed in the last several years, there have been some people that have argued that the move up in real estate prices is sustainable. Mortgage Brokers, Real Estate Agents, Appraisers, and people who lack an understanding of the markets have argued that rising real estate prices are purely based on supply and demand. They point to the fact that the supply of housing is decreasing, while the demand for these homes are constantly increasing. This argument, however, is flawed. In the last several years, homebuilders have been building homes at a record pace. In fact, there are now more housing starts per person than there was 5 years ago. Although there definitely has been an increase in demand for these homes, it has mainly occurred due to the artificially low interest rates and exotic mortgages that have allowed people to purchase homes that were traditionally out of their means.

"Don't you see the bidding wars?" "If you don't by now, you will never be able to afford it!" The sad reality is that most people who have purchased homes in the last several years could not afford to buy a home via traditional means. By this, I mean, that if you took away the creative mortgage packages (zero percent down, interest only, etc.), and forced these homeowners in a fixed mortgage, they would not be able to afford their monthly payment. Incidentally, when interest rates are at record lows, you want to get a fixed rate mortgage. When interest rates are at their highs, and heading lower, adjustable rate mortgages might make more sense.

This idea that people have been purchasing homes outside of their means is validated by looking at the average median home price versus per capita income. As you can see in the chart below, the valuation of median home price to per capita income is way out of historical proportions.

Source: www.piggington.com

Although, this chart specifically depicts San Diego, you can likely apply these results to your local market. Suffice to say, that the average income has not skyrocketed to the degree that we have seen the real estate market skyrocket. Again, this shows that the average person is living in a home that they can only afford because of the low interest rates and because of the type of loan that they have.

Isaac Newton Knows Best

Newton's 3rd Law of Physics states that "for every action there is an equal and opposite reaction". In a similar manner, I believe that with every bubble, there has to be an equal opposite burst. Our economy is heading towards a recession; and the burst of the real estate bubble will be what finally sends it there. Quite honestly, I did not believe that the real estate bubble would last as long as it has. Nonetheless, I know that the longer a bubble lasts, the more dramatic and severe the burst will be.

Real Estate Prices Decline in 2006

In 2006, we are already seeing signs of a slowdown in the housing market. In recent weeks, home loan applications have fallen to a 3 ½ year low. I believe that most everyone who could take advantage of the low interest rates and exotic mortgages have already done so. The continual rise in interest rates will undoubtedly price new home buyers out of the market. Even with an interest only loan or an adjustable rate mortgage, higher interest rates will most clearly mean higher mortgage payments. Given the fact that your average American consumer has negative savings and that the average income is not rising sharply, I see a sharp decline in the demand for new home sales in 2006.

Coupled with a decline in the demand for new home sales, will be an increase of available homes on the market. This increase in supply will likely come from the following sources:

1. New Homes Still Being Built

Even in the midst of declining home loan applications, there are still new homes being built. Because of the multi year rise in real estate prices, home builders have scrambled to build homes and profit from this irrational real estate demand. As a result, there are still a number of developments in the works and new homes that will soon come on the market.

2. The Speculative Home Buyer

According to the National Associations of Realtors, 36 % of the home sales in 2004 were second home purchases. Although I haven't been able to find out the number for 2005, I can assume that the percentage is even higher. As real estate prices start declining, I believe you will see the speculative home buyers sell their houses and take profits (or cut their losses). Because most of these second home buyers view these homes as an investment, they are more quickly to act in the midst of declining real estate prices.

3. The Over-extended Buyer

As it stands, the average American has negative savings. In addition, because they have adjustable rate mortgages, they will be forced to pay more on their mortgage as interest rates continue to head higher. Most of these home buyers do not have the necessary savings income growth potential to keep up with rise of their mortgage. As a result, the likely scenario is that these homeowners will be forced to default on their mortgages and walk away from their homes.

In the midst of growing inflationary concerns, I believe that the Fed will continue to raise interest rates in 2006. The degree to which they raise interest rates will determine how fast this real estate market will begin to unravel.

The Real Estate Burst Effect on the Economy

Without question, the real estate bubble has fueled this US economy in the last several years. I am amazed at the amount of times I have heard about a friend or neighbor who decided to refinance their home, get an adjustable rate mortgage, and take cash out for some type of trivial expenditure. Why not? They would argue. I just made a 200k profit this year. This same irrational exuberance reminds me of the "paper millionaires" in the Dotcom era who pointed to their stock portfolio as a means to justify their spending. Although this spending served to fuel the economy, it also served to further fuel this bubble and send your typical consumer further and further into debt. In the future, those that can afford to pay the additional amount on their higher mortgage will have to "tighten their belt" and not spend as much money in the economy. Consequently, they will hold on to their car a couple of years longer, not frequent their local restaurant as often, and cut back on their overall spending. In turn, this will flow into the economy and we will most likely see a much needed recession as individuals refocus on savings and the re-accumulation of wealth.

The Implications of an Upcoming Recession

Generally speaking, a recession is a prolonged period of time where the economy is contracting. During a recession, you will most likely see consumers spending less money and saving more, a subsequent decline in the stock market, a rise in unemployment, and a decline in real estate prices. The idea is that the economy has to have periods of contraction after years of expansions. From 1991 to today our economy has been constantly growing. Some Economists might argue that we did go through a recession in 2001. I disagree. Although we did have some characteristics that were indicative of a recession, we also had some glaring omissions. How can we have a recession that only lasts one quarter, especially after we just came off a major stock market bubble? Why would real estate prices continue to rise in a time of less spending and more saving? In either case, the recession that is to come will be a multi year recession that will serve to slow down this economy that has been wildly expanding over the last decade and a half.

I see the commodity markets as the premier place to invest during this upcoming recession. Like the recession of the 1970's, I also expect to see rising inflation and soaring commodity prices. Whether you invest in the metals markets, agriculture, or basic raw materials, I believe that positioning your wealth towards commodities will best position you to ride out this housing burst and subsequent recession. If you are interested in learning more about how you can take advantage of this commodity bull market, I am offering a free brochure titled "The case for commodities". Additionally, I also provide a free weekly newsletter to my clients. You can sign up for both at: http://www.wisdomfinancialinc.com/brokers/emanuel.html.