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.

Tuesday, 25 February 2014

Are markets self-correcting?

The economics textbooks will tell you that markets are self-correcting. Is that true?

When markets becomes overvalued buyers will become scarce and the the market will fall back into equilibrium, say the rule books. And when markets are undervalued rational profiteers will buy them back up to their point of fair value.

The technology stock bubble of the late 1990s and early 2000s was a favourite case in point.


A lot of technology stocks, some of which never even made a profit in their entire lifespan, had PE charts that looked something like this.

For a period of time, the market wanted to own anything which was remotely related to technology or the internet and valuations soared. 

Even experienced heads said that the rules had changed and you had to be "in to win it". 

Companies with no profits were instead valued on number of page views ("price per click") and other strange or non-sensical metrics.

When the bubble burst, the market returned more or less to where it was before the bubble - once again reverting to valuing companies on their future earnings potential.

Ultimately, an asset or company which has no cash-generating ability has no value. If a company cannot generate profits then eventually it will have to sell its assets to survive and will ultimately be worth zero.

Yesterday, I looked at the fluctuating fortunes of BlueScope Steel (BSL), a former market favourite with a share price of above $12 and a market capitalisation measured in the billions.


But when the company started making losses, the market valuations fell, and kept falling. And as the dollar appreciated again after the financial crisis, BlueScope was unable to arrest the loss-making tide and the share price fell to below 30 cents.

Although the chart above appears as though the company has made a big comeback, the large leap at the beginning of last year was actually a result of a 1-for-6 share consolidation. Slowly but surely, BSL is moving back to profitability, but it has been a long and painful half decade.

Free markets?

The rule books say that loss-making companies will fail and markets will value companies and assets accordingly.

But do we live in a free market world? Not really. When you stop to consider the news of recent weeks, there are no end of market distortions.

For years, car companies have received subsidies, Qantas is all set to receive a bailout, in the US and the UK we saw banks being injected with liquidity, and so on. 

Markets are not free in the textbook sense. We have a minimum wage and wages awards, copyright laws and patents, trade unions, distorting taxes, state-supported monopolies, and, rather importantly for asset price valuations, an inflationary monetary policy.

Answer?

The answer, then, is that markets are indeed self-correcting to a point. The economics textbooks are correct, but they are not really talking about the world which we live in. Markets are self-correcting, but only within the existing framework and market distortions.

Australia's big banks will never be allowed to fail, for example. A lot of people don't seem to like that, but the economy could not function without bank liquidity, so the banks receive an implicit guarantee. The cost of that should probably be tighter regulation.

In the traditional free market, struggling companies would be allowed to fail, with the idea that in the long run, the stronger companies will survive and make the economy more efficient.

That's not how the real world is, though. 

Real estate

In a similar fashion, property markets are also distorted by tax incentives and policies such as stamp duty, negative gearing rules and land taxes.

Markets are also distorted by first home owners grants, land zoning restrictions and supply constrictions, and a whole range of other factors.

But even within this distorted framework, markets are self-correcting to a point.

If prices become too low, rational profiteers eventually appear and push them back up again. 

Periodic, moderate corrections are welcomed by governing bodies, but prices which fall continually for years are considered poisonous to economies and intervention becomes likely, in the form of low interest rates or other incentives.

If prices rise too, high, on the other hand, buyers become cautious or even disillusioned, and gradually drift away.

Where is the evidence for this? The RBA has shown that repayments on new housing loans have tended to comprise between a fifth and a third of household incomes for decades. 

At times, repayment levels have jumped to over 30% of household disposable income, but that appears to be about as far as Aussies are prepared to go.


Similarly, for all the debate and counter-debate, since home ownership became common after the war, ownership rates have barely shifted. Most people elect to own a home, and some never do, but the ratio hasn't changed a lot. 

If anything, the chart is most remarkable for how consistent it has been in a country with a growing population since the 1961 Census.


The net result of this is home prices tend to rise with incomes over time. You could try to be clever and time the market, but over the past 15 years, there have been crash warnings every year, many of which never eventuated. 

However, it remains true that markets are self-correcting to a point. 

If the RBA's chart shows that repayments on new loans are starting to fall outside that 20-30% band, this may be a signal that the market may become due to self-correct.