Froth

What Is Froth?

Froth refers to market conditions preceding an actual market bubble, where asset prices become detached from their underlying intrinsic values as demand for those assets drives their prices to unsustainable levels. A frothy market is one where investors begin to ignore market fundamentals and bid up an asset's price beyond what the asset is objectively worth. Froth in the marketplace is often characterized by overconfident investors and is a sign that investor behavior and investment decisions are being driven by emotions.

Understanding Froth

Froth and "frothiness" are Wall Street's way of indicating the price of a particular asset is on its way to becoming unsustainably high. Market froth marks the beginning of asset price inflation that the market will likely not be able to support in the future. A frothy market can be the precursor to a market bubble, which may lead to a severe contraction of asset prices, also known as a crash or burst bubble.

The dot-com boom and bust of 2001 and the housing crash of 2007-08 are examples of asset frothiness that eventually lead to burst bubbles. Both bubbles were marked by increased levels of investor speculation that continued until investor confidence waned and sell-offs ensued, leading to a market correction and a sharp decline in prices.

How to Spot Froth in Real Estate Markets

Sketchy Loans Are Common 

As evidenced by the 2008 recession, subprime lending is not a sound practice in a healthy economy. Loaning money to homebuyers who could not qualify for traditional loans can lead to greater default risk.

Yet, the U.S. government still backs loans that some might consider risky, particularly ones from the Federal Housing Administration (FHA) that require only a 3.5% down payment. However, the underwriting standards are higher for FHA loans than with many of the subprime, low-down-payment products offered in the early 2000s.

There's Lots of Leverage at Work 

When someone takes out a mortgage, they're leveraging their money. If a high percentage of homebuyers are making small down payments, then they are leveraging the deal by using the lender’s money. When lenders loosen their standards and allow smaller down payments, this can lead to higher housing prices as more buyers flood the market and compete for the available homes for sale.

Salaries Aren't Keeping Pace With Home Prices 

When housing prices are rising and salaries aren't, this is a good indicator of froth. If someone thinks their local market fits this description, it might be best to wait on buying a house, especially if you’re really stretching to make ends meet. As long as credit conditions from bank lenders are tight, runaway price inflation shouldn't happen, and you shouldn't have to pay much more if you wait.

Interest Rates Rise

Froth might be happening if, as soon as interest rates rise, demand for housing falls. For instance, if interest rates increase by 1% and all the houses suddenly become unaffordable, you’ll likely see a sinking housing market.

Special Considerations

High prices alone are not an indicator of froth. Rather, froth is indicative of unsustainable rapid price appreciation. A market is unsustainable if fundamentals do not support appreciation. By fundamentals, we mean the basic quantitative and qualitative information about an asset that enables investors to make a financial evaluation. In stock investing, this includes analyzing a company's profits, revenues, assets, liabilities, and growth potential.

There is no guarantee that this type of analysis will spot froth as it's happening. However, it can serve a useful purpose to point investors in the right direction and avoid the irrational exuberance typical of overvalued markets.