When legendary rhythm and blues singer Billy Ocean performs “Red Light Spells Danger,” his mind isn’t on Canadian home prices. But with a hat tip to Billy, we’ll use an altered title of his song for our “Red Hot” alert on the Canadian housing market.

Last year we expressed concerns that the housing market is overvalued and may be heading for a correction. We also indicated that overvaluation alone is not always a sufficient reason for a correction, and that it may persist for a long time.

Since June 2015, the housing markets in Alberta and Saskatchewan have weakened somewhat, but the dominant markets of Vancouver and Toronto have steamed ahead. If we were somewhat concerned about a possible correction last year, we have become increasingly worried this year. All the typical bubble signs are flashing “Danger.”

Picture Worth a Thousand Words

Charles Kindleberger, in his famous 1978 book, “Manias, Panics and Crashes,” identified a number of key features of developing bubbles.

Overvaluation and unrealistic pricing are always key elements. This is a picture of a small Vancouver house that recently listed for C$2.4 million. It’s nothing more than an old, nicely painted house in a mediocre neighbourhood, but the agent apparently received multiple offers.

In Vancouver — the priciest market in Canada — the benchmark price of a detached home is now C$1.3 million, 24% higher than 12 months ago and 48% higher than three years ago.  Toronto comes in second with a benchmark price of C$1.2 million, 34% higher than three years ago.

Housing affordability is also way off the scale for the average Vancouver household. The housing market expert Demographia rates a median multiple of 5.1 times or higher as “Severely Unaffordable.”  In Vancouver, home prices are now 11 times the median household income — making it the least affordable city in North America and the third-least affordable in the world, with Toronto not far behind. Even with record low mortgage rates, Vancouver residents now have to fork out 63% of their income to service their mortgages.

Banks and other financial institutions have provided fuel to the housing market fires. Residential mortgage credit is up 17% over the past three years, and personal lines of credit, which include home equity loans, increased by 135% over the past five years.

Another of the key red flags in the Kindleberger bubble framework is the presence of speculation and fraudulent activity. Speculation is difficult to track, but anecdotal evidence of homes selling well above asking prices, multiple offers on the same property, offers submitted with no conditions, and record low average times to sell properties are signs that we are dealing with rampant speculative activity in the hot Canadian markets.

Fraudulent activity is also evident. Last year, the largest alternative mortgage broker in the country severed ties with 45 mortgage brokers who provided fraudulent loan applications. An independent advisory group appointed by the BC government recently provided an interim report highlighting some “disturbing practises” of real estate agents involved in “shadow flipping” (multiple sales of a home before it is registered) and dual agencies.

As Kindleberger noted, overvaluation and irrational markets can continue for a long time. We may again be early with our warning, but it is looking increasingly clear that we will see a correction at some point – and the fallout may be ugly.

Position your portfolio

The Canadian Government and Central Bank have taken some action to cool the housing market, but so far with little effect. Super low mortgage rates and airplane loads of foreign buyers taking advantage of the cheap loonie seem to be the key drivers of the frenzied housing market activity, and they show no signs of letting up soon.

Real estate activity is an important component of the overall economic pie in Canada, contributing 13% of GDP in 2015 — larger than the mining and energy or manufacturing sectors. A sharp and prolonged real estate correction will reduce employment, income and household wealth with a considerable negative impact on consumer spending.

Stocks to avoid during a housing market correction will be the pure mortgage lenders, such as Home Capital Group, and real estate brokers, such as Colliers International Group.

The large Canadian banks have a variety of revenue sources and relatively conservative home loan portfolios, but all will take a hit from a sharp housing market correction. However, banks without a meaningful international profit centre and with large portions of their loan portfolios extended into the domestic market, such as Canadian Imperial Bank of Commerce or National Bank of Canada, will probably be hurt most by such a correction.

Royal Bank of Canada (TSX:RY,NYSE:RY), one of our Dividend Champions holdings, has a C$272 billion home loan book, accounting for 56% of its total loan book. While the book is partly insured and fairly conservatively managed, we have decided to sell the stock from our portfolio. This leaves us with only one bank in the portfolio, Toronto-Dominion Bank (TSX:TD,NYSE:TD), which has a smaller mortgage loan book and is more conservatively positioned than Royal bank.