Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Monday, 31 December 2012

Is housing affordability really the best it has been in a decade?

Read my article today on Property Update here.

Of course, since I wrote this article interest rates have fallen even further, the cash rate now sitting at just 3.00%.

The top-down approach to property investment

Top down approach
In times gone by it was fairly common for property investors to look for investment properties close to where they lived. There isn’t necessarily anything wrong with that, depending, of course, on where you live!
Through the 1970s and 1980s, Australia experienced prolonged periods of high inflation as evidenced in the chart below:

This effectively devalued mortgage debt and so virtually anyone who adopted an approach of borrowing to invest in an asset such as property over anything even approaching a reasonable time horizon came out well ahead.
You will note from the graph that Australia’s Reserve Bank (RBA) adopted an inflation target in 1993. Since that time, inflation has been notably lower.
While the future with regards to inflation is always somewhat uncertain, it seems to be a reasonable assumption that inflation in the future is likely to be consistently lower than was seen through those earlier decades.
For this reason, I believe it is no longer likely that simply by investing in property “in your own backyard” is going to be good enough to secure your financial future.
Invest through two full property cycles for wealth
Building wealth through property investment isn’t necessarily easy, but the fundamental concept can be very simple.
The investment approach which is successful most often for most average investors is to invest in a property which appreciates in value and then, rather than selling that property to “lock in” the investment profits, to refinance the property and use some of the equity that has been created to invest in further investment properties.
Then over the coming years when the newly-acquired properties also appreciate in value, significant equity will have been created which the investor may use for whatever purposes are deemed appropriate.
Some will then liquidate the investment properties to invest in so-called “income assets” such as high-yielding shares or fixed-income investments, including investment grade corporate notes or bonds and term deposits.
Others will simply draw out a portion of the equity for living costs.
Often a hybrid approach is used, such as selling some of the properties in order to extinguish some of the debt while retaining a number of properties for the future.
Aggressive investors who are less risk averse may look to refinance several properties to invest in yet further properties.
The in-built assumption
Of course, you will have spotted the in-built assumption in the approaches discussed above: that property always goes up in value. This is by no means necessarily the case.
Indeed, while it was possible in earlier decades to more or less buy any property and see it ‘appreciate’ (or was it often the case that mortgage debt was inflated away?) markedly due to high levels of inflation, this may not continue to be the case in the future.
Consequently, investors may need to adopt a slightly different approach to those that worked in the past.
The first thing that investors might look to do is to invest in a different city or state to the one in which they live.
Counter-cyclical investing
Smart investors will look to invest counter-cyclically through seeking out a city or region which has not recently experienced growth in order to capitalise on the next growth cycle.
Thus, investors today might be more inclined to look away from Melbourne than they would have been in, say, 2007, for since that time there has been an enormous boom in values.
While the long-term fundamentals  of the city such as population growth and a diversified range of industries look great, Melbourne is unlikely to be the next major capital city to boom in value.
Variously, cases might be made for Brisbane, due to the city having experienced lacklustre growth for more than half a decade now, or my preferred long-term choice, Sydney’s inner and middle-ring suburbs.
That said, if you told me that Perth was tomorrow’s hotspot due to its sharp population growth, its strong growth in resources-based Gross State Product and real wages, I would find it hard to disagree with you.
From Macro to Micro
In the world of economics there are two main forms of economist: macro and micro.
Macro economists, as the term suggests (from the Greek makros, meaning large) tend to focus on the big economic picture such as a government’s policy decisions, the national level of unemployment or, for example, the prevailing rate of inflation.
As a historian specialising in industrial and economic history, I am interested in macro trends, and the effect of government (and central bank) policy on the economic health and wealth of nations. So in that respect, you would say that in my specialist field I adopt a macro or “top down” approach.
On the other hand, micro economists (micros being the Greek work for small) focus more upon the day-to-day decision-making processes of individual businesses or households.
Micro economists may be more interested in the field of applied economics, becoming experts in one specific field such as experts on Goods and Sales Tax (GST) or a particular type of commodity.
Social economic historians tend to be more interested in developments to this level of micro-detail, looking at how the universal laws of supply and demand impact upon individual circumstances. They may often adopt a highly statistical or price-based approach to their studies.
Property investors as macro and micro experts
As I alluded to above, I would suggest that if you want to become a property millionaire – and there are plenty out there who do – to achieve this goal today, you need to become a macro expert and a micro expert.
What do I mean by that?
As I explained above, future property price growth in Australia (in my opinion) is likely to be materially lower than it was in the past.
Therefore, if you want to become wealthy through property it is important to be able to identify property cycles and to invest in whichever city you deem has the best prospects for growth.
Remember: look beyond your own back yard!
This is where your macro-expertise comes in! Identify population growth trends, prosperous cities with a range of industries and real wages growth, and, importantly, cities which have not experienced a boom in growth in recent times.
Then, using a top down approach, you need to become a micro expert in that city by first finding the property types and then the specific streets and individual properties that will strongly outperform the misleading “median price growth” so beloved of the financial press.
If you are able to do this and can invest in a property which booms in value, you then need to turn your focus away from the city which has served you so well, to seek out the next boom location. Re-draw some equity and move on to re-investing in further properties.
If you can successfully select another boom location and hold your newly-acquired investment properties through another growth cycle you will be well on the way to wealth through property investment.
So, remember the top down approach: start with the state, then the city, then the suburb, the street and the individual property.
From macro to micro, you will be on that elusive road to financial success.

Tick, tock...the fiscal clock on its final countdown

No real surprise that self-interested US politicians have yet to come to any agreements on a fiscal cliff deal as the clock keeps ticking towards the deadline.

Should they fail to do so, a series of tax cuts expiring would lead to painful decrease in US family discretionary expenditure and consumer confidence would doubtless take a battering. 

Aussie stocks slipped by 0.5% as they priced in the possibility of a stalemate.

Nevertheless, 2012 was a fine year for stocks here, with the index closing up around 15% for the year. This will result in a welcome boost to superannuation balances.

The early part of 2013 may well be rocky but the general consensus is that the next year is likely to be a good year for growth assets.

A very low cash rate of just 3.00% (which may yet sink even lower) is forcing many away from the comfort of fixed interest investments and into the so-called  "risk assets".

With higher-yielding blue chip stocks offering dividends of ~ 5-6%, any further falls in the cash rate will cause many of those holding cash and cash equivalents to reconsider their strategy.

While short-term predictions of this nature are always of limited value, history suggests that the odds of 2013 being a good one for shares are good.


RIP Tony Greig, a former Waverley CC cricketer in Sydney and the England cricket captain during South Africa's years of exclusion. In later years, Greigy livened up our TV screens with his ever-entertaining commentary. A great man who will be missed.

10 New Year's Resolutions for new and experienced investors

10 New Year’s Resolutions
I don’t necessarily believe that you have to wait until a new year to make great changes to your life, for it is true that change can happen in an instant.
Nevertheless, January 1 is as good a time as any to wipe the slate clean and resolve to make the next year a great one.
Here are my 10 New Year’s resolutions for investors:
1 - Set yourself a dream, not just a goal
Everyone can have great dreams, so why not set an inspiring one for yourself? A dream that gets you out of bed each morning with the drive and enthusiasm to achieve your greatest goals.
A dream is more than just a monetary goal. Saying that “I want to be rich” tends to motivate people for a short amount of time, but then they seem to lose interest.
What you really need is a dream, a picture of the life that you want to live.
This will keep you motivated through the hard times. And there will be tough times, for becoming a successful investor is fundamentally very simple…but it isn’t easy.
You will need the fortitude to keep going when everyone seems to be telling you it can’t be done or when markets are going against you, and you will need to make some sacrifices today for a better tomorrow. It really helps if you can…
2 - Surround yourself with positive people!
There are always people on hand who will attempt to pull you down.
They may have any number of reasons for doing so.
The reasons don’t matter, but what is important is not let this stop you from achieving your dream. That is why these people are sometimes referred to as “dream stealers”.
Make a resolution for 2013 to surround yourself with positive people who will push you forward and inspire you to be the best that you can be.
There are too many negative people in the world. Don’t waste your valuable time on this earth worrying about what they say about you, instead resolve to be positive and find like-minded people to be positive with. And then…
3 - Just get started!
There are always a thousand reasons why not to get started in improving your finances today, or why not to start investing.
The best course of action is almost invariably to get started now and resolve to learn from any mistakes that you do make.
The alternative is simply to keep procrastinating. But if you aren’t going to do it now, then when will you?
Make 2013 the year you just get started and you will begin to reap the rewards down the track. But don’t just start out in a half-hearted way, instead…
4 - Be enthusiastic!
If you aren’t going to be enthusiastic then how can you expect those around you to be so?
Lead by example and be the most enthusiastic person in your circle of family and friends! With your new-found enthusiasm, then…
5 - Commit to continually learning
When it comes to personal finance and investment, there is always more to learn. Always!
The best thing you can do is to get interested in finance and commit to learning something new every day. Eventually it becomes fun, and then you will continue to learn without even thinking about it. As you have agreed with yourself to keep learning, you will then be able to…
6 - Set a strategy
Reaching your dream will require enthusiasm and fortitude to keep going, but it also needs a strategy.
Will it be through setting up a business? Deciding to invest in shares? Or will investment property be your thing? Ultimately you will need a vehicle to reach your goals.
Make 2013 the year that you set your strategy. Don’t worry, for your strategy can evolve and change over time. But it’s best to consider at the outset what your strategy will be and then get started. However, you won’t get very far at all with any strategy unless you…
7 - Keep expenditure low
It’s amazing how much money we as humans have the capacity to spend in the modern consumerist world. There is always a better car, holiday or house we can buy.
It doesn’t matter who you are, whether you are just starting out or whether you are Bill Gates – the fundamental rule is the same and that is that you must be able to spend less than you earn otherwise you will never get ahead financially.
If you want to reach your dreams, resolve that 2013 will be the year that you stop spending money on “things” that you don’t need. Instead, invest those extra funds in assets which pay you income and grow in value.
If you keep doing this for long enough and you will surely reach your dream. But you have to remember and…
8 - Accept that dreams require sacrifice
Think of anyone you know who has attained great success. It is almost always the case that they made some great sacrifices to get to where they are today.
For sports stars, they often sacrificed much in their youth in favour of training grounds.
Others sacrificed the security of a monthly pay cheque to go into business. A great many people achieve great things simply by sacrificing today’s luxuries in favour of making investments.
It is often amazing what seemingly small differences in lifestyle can add up to over a period of years and decades.
All great dreams require some sacrifice, so accept this and resolve to make sacrifices today so that one day you can achieve your dream.
Your success won’t come in a simple and linear fashion, there will be problems, setbacks and unsettling times, but that’s OK, simply remember to…
9 - Learn from mistakes and move forward
We are human and therefore we will make mistakes.
It is OK to make mistakes! In fact, the best investors are often those who have made the most mistakes over a period of decades and each time they make a mistake they learn from it – and they don’t ever make that mistake again.
To err is human. Learn to see mistakes as learning opportunities and just keep on going and then...
10 - Never, ever give up!
Last, but not least, resolve to never, ever give up.
Nothing that is worth having in life ever comes easily so it is a given that you will face obstacles and tough times when nothing seems to be going right.
But if you resolve to never, ever give up then you will be unstoppable. In fact, if you can commit to only one resolution, this should be it.
Life seems to like to throw obstacles in our way, and sometimes doors seem to be continually slammed in our face. But if you bang on the door loud enough and for long enough, life usually just decides that it has found a stubborn match and decides to let you through.
Why not resolve to be one of those people in 2013?

Sunday, 30 December 2012

What is the future for our pensions and welfare?

The social security cap
In early 2012, the UK Conservative government caused more than a little controversy when it proposed a cap on social security benefits at £26,000, which is the equivalent of a before tax salary of £35,000.
The median gross income for full-time employees in 2011 was only £26,244.
Of course, the British press had an almighty field day with this (cue interview with chain-smoking unemployed single mother claiming that she would “never be able to cope on £26,000”…) followed by the equally predictable backlash from the tax-paying workforce.
I believe that what we saw played out in this little episode was a significant precursor of things to come.
Increasingly, developed world governments will be forced to make social security cutbacks as the global population ages and their budgets groan under masses of debt.
The Welfare State
The concept of the Welfare State began with the ideas of Otto von Bismarck, the first Chancellor of Germany, where he built upon the tradition of welfare programs of the pre-unification states of Prussia and Saxony, which had begun as early as the 1840s.
The idea was simple: while in the workforce workers were to make contributions, but if a worker became unable to work due to unemployment or being infirm then they would be taken care of.
The welfare reform ideas were taken forward in Britain under the Liberal Prime Minister Herbert Asquith between 1906 and 1914, particularly in the guise of the Old Age Pensions Act in 1908.
The Beveridge Report of 1942
One of the (very, very) few papers I wrote of any lasting worth as an undergraduate was on the impact of the famous Beveridge Report of 1942. Beveridge’s sweeping proposals promised to tackle the five major social maladies of Want, Disease, Ignorance, Squalor and Idleness.
To cure these ills, argued Beveridge, the Government should provide adequate income, education, healthcare, education and employment for all.
What Beveridge suggested was that the working population should pay a national insurance contribution and free healthcare should be available to all.
At the end of the Second World War in 1945, many of the proposals were implemented through a series of Acts of Parliament. The National Health Service (NHS) was born, a pioneering act which was well recognised by the Brits in their recent London Olympics opening ceremony.
Problems with Pensions, Social Security and Welfare
Rewind to the American Civil War in 1861, where the Confederates and Unionists are finding great difficulty in recruiting new soldiers and thus come up with a novel plan of offering generous life pension benefits to soldiers and their widows.
While one might have expected the last payments from these pension schemes to have dried up perhaps five or six decades later, in fact, quite incredibly, payments were made right up until 2007 (an entrepreneurial young woman had taken it upon herself to wed a senior citizen and continued to draw a widow’s pension for virtually her entire adult life until she died at the age of 97).
This mildly amusing anecdote highlights two of the great problems facing governments when it comes to pensions and welfare.
Firstly, it is difficult to envisage and forecast the full effect and costs of a pension scheme when new rules are introduced. Secondly, while there will always be those who are genuinely in need, equally, there will always be a minority who attempt to exploit the system to the full.
A further problem – and here I’ll get a slap on the wrist for my capitalist views – is that social security benefits introduce a disincentive to work, as has been experienced in a number of western European countries.
From an economic perspective this lowers productivity. From a social policy perspective, the effect can be disastrous, creating an effective underclass in society who have never been employed, and more damagingly, will never have any intention of working.
I should point out that I grew up in a socialist family and am of course aware that there are those who are genuinely in need of income support. But it is also unquestionably the case that on both a macro and a micro level, welfare has brought with it some social problems too.
The major demographic shifts
The concept of the welfare state was introduced at a time when it was not expected for many to live for a long time in retirement. World Wars played a part in this, as did lower living standards which resulted in decreased life expectancies.
Today in Australia, if you live to the retirement age it is expected that a man will live for almost two decades in retirement (and a woman longer). And it is entirely possible that you could live for closer to four decades in retirement.
This shift alone has turned the concept of welfare on its head.
But there has also been a major generational shift and that is the on-going transitioning of the Baby Boomer generation into retirement.
In the US more than a tenth of the population is above the retirement age, and this figure is expected to increase to a fifth over the next few decades. The country has effectively bankrupted itself (by most definitions of the term) and with $16.5 trillion in debt the US once again is approaching its debt ceiling in late February 2013.
Some countries have dire prospects that are far worse still – in Japan more than a fifth of the population is already above the retirement age and as fertility rates have dropped, this figure could balloon dramatically to perhaps half of the entire population by 2050. Japan’s demographic nightmares have resulted in a desperate spiral of deflation which is feared by every other developed economy.
As millions are moving into retirement with greater life expectancies than ever before, government budgets will begin to buckle under a mass of healthcare and pension benefit expense.
6 solutions for governments
There are a number of steps which governments will be forced to undertake in order to combat the problem of mounting social security costs.
1 Tightening up the welfare system
It would have seemed unthinkable in times gone by that ‘tip-off’ phone lines would be introduced to inform upon those claiming benefits illegally. Yet these and other measures will gradually become accepted as commonplace as governments attack the welfare problem from a cost-saving angle.
2 Increase the working age
The current retirement age of 65 will inevitably be increased over time in order to increase the numbers of those in the workforce and decrease the numbers of those who are claiming pensions. Australians might expect to see a retirement age of 70 in the not-too-distant future.
3 Increase pension contributions
The powers that be in Australia showed great foresight in the introduction of the superannuation guarantee. However, the current employer contributions of 9% are still considered to be too low.
Over the next seven years, compulsory superannuation contributions will be increased to 12% thus:

Source: ATO

4 Decrease pension and healthcare benefits
Theoretically, governments could reduce pension and healthcare benefits. However, the basic Age Pension benefit in Australia of around $380 per week is already at a level which many would consider to be sustenance.
5 Increase taxes
Governments can elect to increase taxes, although in Australia we already have relatively high marginal rates of tax. Increasing them further may hinder productivity and economic growth. The trick, as always for a government, is to pluck the goose as far as possible without making it hiss.
6 Increase the taxpaying workforce
Australia is already well aware of its need to populate. Therefore, expect the population to increase massively from 22.86 million today to around 30-35 million over the coming decades.

Saturday, 29 December 2012

Aussie shares will open down on Monday as Obama offers no new deal

It has been almost boringly predictable with politicians continuing to squabble right up until the 11th hour on the fiscal cliff negotiations.

US stocks have fallen for five days in a row as the deadline approaches, falling by 1.9% for the week, with the Dow down some 158 points yesterday.

Surprisingly (to me at least) Aussie stocks have survived unscathed to date, but that won't last and the markets will open sharply down on Monday unless there is significant good news between now and then.

Of course, markets will be as worried by the US again approaching its debt ceiling.

When this happened last year the US was donwgraded to a AA rating and stock markets corrected by around 16% in August 2011.

The consequences of globalization

The 5 key factors of globalization
What exactly is globalization?
Back in 2000, the International Monetary Fund (IMF) identified four basic aspects to globalization: trade, capital and investment movements, the dissemination of knowledge and migration. We already know that each of these aspects are impacting Australia significantly.
In turn, these basic aspects will affect economic trends. British economics editor E. Conway identified five key economic factors of globalization, these being:
1 Free trade
Major barriers such as tariffs on imports and exports have been removed.
This has included China’s removal of export restrictions leading to a raft of cheaper goods flowing out from that country.
2 Outsourcing
Developed countries with expensive labour such as the US, Australia and the UK have shifted operations to cheaper climes such as Mexico, India and China, increasing profitability.
Controversially, working conditions in the overseas regions are frequently poor.
3 Communications revolution
The internet has revolutionised communications and brought connectivity to millions around the globe.
4 Liberalization
The fall of the metaphorical ‘Iron Curtain’ across Europe, for example, has allowed previously closed borders to be opened, thereby allowing greater interaction between countries.
5 Legal harmonization
Countries around the world have endeavoured to standardise and align laws on, for example, intellectual and property rights.
This helps to ensure that exported products are compliant in the countries they are sold to.
The benefits of globalization
Globalization has brought great new wealth to economies such as Brazil, India and China.
It has also helped to reduce inflation in many of the developed nations, which had previously been scourged with rampant inflation.
Indeed, until the financial crisis of 2007 and beyond, the causes of which were mainly related to subprime lending, globalization was said to have led to a ‘Great Stability’ for a period of around a decade and a half.
Optimists might also argue that greater trade between countries could lead to the spread of democracy and peace between nations as relations improve, though this is always somewhat doubtful (it was once noted that no two countries with a McDonald’s restaurant had been to war with each other, though this is no longer true).
As wealth is created for the professional classes, Communist countries may also eventually embrace more democratic ideas.
The problems with globalization
Conway also identified three main criticisms of globalization:
1 – Human rights
We have seen countless examples of major companies and brands being found to have operated sweatshops in which conditions were desperately poor.
2 - Cultural
The predominance of major western brands makes it very difficult for indigenous companies and brands to survive and thrive in developing countries.
3 - Inequality
Perhaps the most troublesome problems from globalization will be related to inequality. While free trade will create billions in new wealth, it is inevitably the case in a capitalist world that the wealth will not be shared equally.
The rise and rise of inequality
Inequality is nothing new. As the Industrial Revolution swept across Britain in the eighteenth and early nineteenth centuries enormous wealth was created for the factory owners while the newly-urbanised workers experienced great poverty.
But, worryingly, over the last few decades it seems that the gap between the ‘haves’ and the ‘have-nots’ has begun to increase once again.
This is true both in terms of inequality between countries (e.g. between western European and sub-Saharan African nations) and between those within developed countries: those who build significant wealth and those who are unable to.
Developed countries tend to practice wealth redistribution by taxing higher earners at higher rates and providing lower income earners with breaks and benefits. This ensures that developed countries have few genuinely ‘poor’ people on most global measures of the term.
However, even these ‘redistribution dividends’ are not preventing the gaps between the wealthy and the rest becoming ever wider.
Why is inequality increasing?
Times of rapid change, such as the aforementioned Industrial Revolution, do tend to create great inequality.
The world is now moving through a great information or communications revolution which creates massive wealth for those who capitalise thereon, but renders other industries obsolete. Others may find that their jobs have been shifted to other more inexpensive countries.
There are a number of other reasons for the increase in inequality including education, the distribution of wages and the use of tax havens by the wealthy.
It is true that the wealthy have always known how to use great leverage in a tax-effective manner, how to compound their wealth and and how to protect it.
Is inequality bad for a country?
Economist Robert Barro has attempted to show that, in developed economies, even if a country has growing inequality, this can still mean that the population can be better off overall.
This is not the case in the developing world where inequality merely leaves many in poverty.
However, inequality naturally brings with it other problems. Humans naturally tend to compare their lot with that of their immediate neighbours and therefore unhappiness and perhaps social unrest, crime and violence can ensue as a result of inequality (even if conditions for the lower socio-economic classes steadily improve).
Inequality seems to be here to stay
Whether we like it or not, it seems that inequality is here to stay and is only likely to increase. Australians would be wise to consider how they can have a plan to secure their own financial futures.
Some will secure themselves financially through owning successful businesses and others will look to the share markets to build inflation-protected wealth.
Over the long haul those who invest in a diversified portfolio of shares from the industrials index are likely to outperform those who opt for resources stocks (which have tended to disappoint, as capital is spent on searching out and developing new projects rather than being returned to shareholders as dividends).
Others still will look to investment property. As I’ve discussed many times, property is unlikely to have such an easy ride in the future.
The increasing inequality that Australia experiences over coming decades will manifest itself in the property markets too.
Many with a vested interest continue to suggest that it will be remote property markets which outperform, but in my opinion they are wrong. While trickling population growth might increase demand in regional markets marginally, real property price growth cannot be created without the real wealth of the buying population increasing.
This is precisely why significant property wealth will be created only in a handful of major hubs around the vast continent of Australia.
In fact, in my opinion, in the next property cycle it will no longer be good enough to simply rely upon households taking on ever more debt.
As and when Australia experiences a period of extended deleveraging, which has been seen in many overseas markets, we might expect the trends that have been played out elsewhere to be reflected here too.
That is to say, regional markets and the less popular outer suburbs will slide sharply or drop in value, but the most popular blue-chip suburbs in the four major capital cities will show far greater resilience and return stronger still.

Friday, 28 December 2012

Still no fiscal cliff deal yet Aussie stocks finish 2012 at a 19 month high

Quite remarkable!

It is, according to my calendar at least, December 28, and we still have had no deal on the fiscal cliff tax negotiations.

Yet Aussie stocks continued to forge ahead in the last full trading day of 2012.

Australia, and indeed the rest of the world, should now be hoping that US politicians see sense and at least agree to defer the fiscal negotiations by "kicking the can down the road".

I don't think many of us would enjoy the fallout if it eventuated: tumbling commodity prices, a strengthening Aussie dollar, very sharp stock corrections and instantly evaporating consumer confidence.

No thanks!

What will happen to the credit cycle in 2013?

The Black-Scholes equation
Back in the days when I wrote company Annual Reports, one of the many headaches for us accountants came in how to value share options issued to directors and key management personnel in the Remuneration Report.
Fortunately in 1973, unsurprisingly it was two men named Mr. Black and Mr. Scholes who devised a complicated-looking equation which could value such options.
The neat result was that you drop variables into the equation such as the prevailing share price, the option exercise price and the number of days until the option expiry, and the equation would calculate a rational value of the option.
So far, so dull.
The miracle equation?
But when the equation became widely known it was anything but dull – it was the miracle equation which could produce the Holy Grail: risk-free investment!
It seemed possible to perfectly hedge an option by buying and selling the underlying asset in order to eliminate risk, which is every investor’s and every hedge fund’s dream outcome.
The equation implied that there is only one true price of an option and also made a number of key assumptions, one of which was that there would always be available buyers and sellers of a stock, particularly when short-selling.
It was adopted by investors everywhere and contributed further to the boom and bust cycles.
Markets are not rational
But therein lay a problem. The Black-Scholes equation could only eliminate risk if it were true that investment markets are always rational.
However, investment markets are driven by human emotions including fear and greed and therefore are anything but rational.
The 1987 Black Monday crash demonstrated perfectly the irrationality of markets with the Dow falling by 22.6% in one day.
We saw the pattern repeated in the financial crisis when markets plunged…and then kept on falling with scant regard for anything approaching rational behaviour.

Crucially when markets crash in this manner there is not always an available buyer for your asset regardless of whether you are hedged or not.
This demonstrates one of the great truisms of investment: there is always some prevailing risk.
Credit crunches
Housing market credit crunches can sometimes work in a similar manner.
It had been thought that over time markets would learn from the mistakes of the past and become more rational, and booms and busts would become a thing of the past. But this has been shown to be incorrect, with cycles as much in evidence as ever.
When a credit cycle reverses, sometimes the supply of available credit dries up when, for example, lending institutions collapse or become unwilling to lend while fearful of toxic assets. This was seen recently in the US with dramatic consequences.
The lack of credit sees dwelling values fall very sharply and businesses becoming unable to operate effectively. A credit crunch is always and everywhere felt very painfully by the economy.
The Minsky Moment
The ideas of Hyman Minsky, which previously didn’t receive a great deal of attention are now all the rage, particularly with academics and theorists. Minsky noted that investment markets move through five stages in a cycle:
·         Displacement
·         Boom
·         Euphoria
·         Profit-taking
·         Panic
When credit cycles reverse, Minsky argued, there comes a point or key moment where asset values fall below the value which they were bought for, panic selling ensues and then the decline in asset values accelerates as panic eventuates.
As recently as the middle of 2012, the usual doomsayers were adamant that house price falls would accelerate, and yet it did not happen in the second half of the year.
Instead what eventuated in Australia were relatively moderate falls in dwelling prices through 2011 and the first half of 2012, before the property markets stabilised.
And so to 2013
Of course, the short-term future is always inherently uncertain and further falls could yet be witnessed.
Almost without exception the forecasting houses have predicted moderate property price gains in 2013 due to the Reserve Bank (RBA) having dropped interest rates from 4.75% to just 3.00%.
On the other hand, for at least the fifth consecutive year now Professor Keen is predicting property market corrections, although he has seemingly toned down his infamous “40% crash” claims to more of a “slow melt” theory.
Who is right?
My thoughts
The correction in the property markets through 2011 and the first half of 2012 was healthy for Australia overall. It is not desirable for property markets to continue to boom for year after year leaving all other asset valuations in their wake.
Ultimately, when credit cycles reverse there are only really two things which can happen. One is that panic ensues and prices crash, and the other is that prices ease moderately for a prolonged period of time before stabilising.
Although there are thousands out there praying for a crash, we should always be careful what we wish for (the same goes for property bulls who are hoping for yet lower interest rates). A property market crash destroys consumer confidence and is likely to result in a full blow recession, high rates of unemployment and other fallout.
It seems that, to date at least, we avoided the crash, but why?
There are two main reasons. One is that the major bodies such as the RBA, the Government and the banks will do anything in their power to engineer a softer landing for prices.
The second point is related to the growth in population. A word of warning: whenever someone says “it is different here!” that should be an automatic red flag, but I’ve never understood why Keen and the gang insist on comparing Australia with Japan.
Sure, Japan’s property prices fell and fell into a negative spiral. But look at the difference in what is happening to the respective populations of the two countries. Australia is populating at an incredible speed and will continue to do so for decades to come.
That is a very stark contrast with Japan, whatever the Minsky model might say.
“But I bought a house for $X…”
As sure as night follows day someone will enter this argument with a comment such as “in 1990 I could buy a Sydney house for $300,000”.
I’ve written many times about why we won’t see those prices again, including the growth in population and demand, the growth in two-income households and, most pertinently, the fact that home loan interest rates today are no longer at 17% and have not been so for more than two full decades.
There has been a structural shift towards lower rates which inevitably sees households gearing up.
Can investors still thrive in times of moderate growth?
The final key point is that property investors do not buy “the housing market”. If they did, then property wouldn’t be much of an investment.
Instead, smart investors look to invest counter-cyclically in properties close to the median price, in land-locked suburbs in major cities experiencing massive population growth.
The headlines may trumpet that “property prices only matched inflation” or “property prices slipped in real terms” but thousands of investors secured their financial futures in only the last half decade simply by investing in properties in massive and growing demand.
Will the next decade be any different?