Australia, UK only two housing bubbles left
Would need to fall 42pc to return to trend
“As soon as rates go up, the game is over”

THE Australian and British housing markets are the last two bubbles left in the wake of the financial crisis, and it is only a matter of time before they crash, warns legendary US investor and co-founder of global investment management firm GMO, Jeremy Grantham.

Mr Grantham famously reported a year before the global financial crisis: “In five years, I expect that at least one major bank (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist”.

The Australian reported he said yesterday that Australia had an unmistakable housing bubble and that prices would need to come down by 42 per cent to return to the long-term trend.

“You cannot possibly miss it,” he said.

“The price of housing typically trades about 3.5 times of family income and in bubble it goes to 6 or . . . 7.5 (times).

“Australia is having one now. You are at near 7.5 times family income . . . which suggests you are twice the size that you should be.”

GMO is one of the biggest investment management firms in the world, with about $106 billion in funds under management, and is considered to be an authority on asset bubbles.

Mr Grantham, who is in Australia to meet with GMO clients in Sydney and Melbourne this week, said any bubble could be an exception to the rule.

“Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different,” he said.

As an example, he cited the British housing market bubble of 1989. At the time, he said people dismissed the bubble because there was no more rezoning, creating a land shortage and as such, they believed prices would rise forever.

“Seven years later, in 1997, they hit the lowest multiple of family income since the record books started in 1945. It’s always the same old argument, they are not making any more land.”

In Australia’s case, Mr Grantham described the housing market as a “time bomb” just waiting for interest rates to increase and become impossible to support.

Since last October, the Reserve Bank has raised the official cash rate six times. The rate is now 4.5 per cent.

If the Australian housing market did not return to the normal multiple of family income, he said “it will be the first time in history.”

“Sooner or later, the rates will go up and the game is over.”

Read more property news in The Australian.

But before we get on to today’s Money Morning, a brief announcement…

The guys and gals at the Melbourne Adam Smith Club have been crazy enough to invite your editor to be the guest speaker at their May dinner function.

You can download an invitation to the event by clicking here. So, if you’re in Melbourne and you’ve got $45 to spend on a curry dinner and listening to your editor waffling on for half an hour or so then feel free to sign up for it.

We’ll look forward to seeing you there.

But for today, this…

“Greece on the edge of abyss as riots turn deadly”

So says today’s The Age newspaper. Perhaps now the mainstream commentators and finance professionals might start taking things seriously.

For weeks we’ve seen “experts” telling us that Greece will be an isolated event. That it could have an impact elsewhere in Europe, but it shouldn’t have any bearing on the US or Australia (Australia’s different you see).

Then at the start of this week talk of contagion started to do the rounds. But again, maybe Europe and the UK will go pear-shaped, but that’s all. We’ll be fine. Our lovely banks don’t have any Greek exposure.

But now today we’ve got “abyss” being used.

That’s hardly surprising considering the deep mess Greece and the European Union is in. And quite frankly it’s something that should be taken seriously.

We’re not talking about common-all-garden riots here. We’re not talking about World Economic Forum style riots with a few bags of flour being thrown and the odd urine water bomb splashing across the old bill.

It’s not the type of riot where the participants turn up for a bit of copper baiting and argy-bargy, fully expecting to return to their day job in the call centre on Monday morning. From what we can see it’s yer proper lootin’ and a killin’ civil unrest.

But we’ll see. You never know, it could all blow over before you know it. However, we’d want pretty decent odds if we were going to place a bet on it.

So who’s to blame for the Greek mess? Are the Greeks behaving like spoilt brats? Do they deserve the punishment that’s being dealt to them? Haven’t they received all the benefits of government largesse?

It won’t surprise you to learn that we firmly place the blame on the government. Sure, the Greek public aren’t completely innocent, thinking they could have something for nothing. But when it comes down to it, the prime reason for the current mess is the politicians and their insatiable appetite for power.

I’m afraid it’s the nature of the political beast. And it’s why we believe in a minimalist government.

The more powers that politicians are granted, the more they’ll want. The more they get to control things, the more they’ll want to control other things.

Eventually it reaches a tipping point. The government ends up having its fingers in so many pies its actions have the biggest impact on the fortunes of the economy. You can see that in Greece, and you can see that in, er, Australia…

Just look at what the Fairy Ruddfather has done to the markets this week. The impact has only been this big due to the excessive influence of government.

And it adds further evidence to support our claim that Australia does not operate a truly free market. In a free market with limited government, the government would not have this kind of power and could therefore not make these decisions.

As we’ve pointed out all along, it is the excesses of government that is the overwhelming negative influence on the economy, not free enterprise.

The front page of today’s Australian Financial Review (AFR) has political hack Laura Tingle leading with:

“The war of words over the resource super profits tax has overshadowed how the Henry review has presented the government with a new fiscal policy lever to control the economy. The lever is a new tax which, as a macro-economic policy, could reweight the way the economy works.”

To free-marketeers that kind of statement is enough to make you drop your copy of The Wealth of Nations into your bowl of cornflakes of a morning.

We love the last part especially; it “could reweight the way the economy works.”

See what I mean about the obsession for hapless bureaucrats and politicians to control things? They just can’t help themselves.

The idea that the Resource Super Profits Tax is a new lever to control the economy is just plain madness. But again, it’s the overconfidence of bureaucrats who believe they saved the Australian economy from disaster.

We’d love to hear from Ms. Tingle her explanation of how economies work. Our guess is that she believes it involves politicians and bureaucrats pulling and pushing levers like an old signalman.

Clearly Ms. Tingle and other government and tax lovers have some bizarre idea that economies can be directed at the whim of bureaucrats just as a child can control a toy train set.

In fact, in a Money Morning exclusive, below is a photo we secretly took this morning of a government bureaucrat in action – not surprisingly he’s sitting down on the job (probably an occupational health and safety thing):

Obviously the lever that’s been pulled right forward is the Australian housing market! “Full steam ahead Gordon…”

Anyway, the Keynesian hordes are still blindly pushing on with their crazy ideas. Not content with getting the global economy into the current mess they are determined to press ahead with even crazier ideas.

Page 71 of today’s AFR has John Freebairn writing:

“The RSPT could be much higher, close to 100 per cent without deterring the investment.”

What is he going on about? Can he seriously suggest that if you impose a 99% tax on something that investors will still pile in?

Apparently Mr. Freebairn holds the Ritchie Chair in Economics at the University of Melbourne. Based on his attitude to taxes we can only assume it must be the Ritchie Benaud chair, because whatever this Ritchie is, he or she can’t have anything to do with economics.

But at least he’s man enough to admit to the charge we levelled earlier this week. That the Super Profits Tax was nothing more than a backdoor to nationalisation:

“The RSPT plus corporate income tax collected will rise with booms, when capacity to pay is greater, and fall in slumps, when capacity to pay is reduced. In effect, government, on behalf of the citizens who own the basic resources, becomes a shareholder in the mining industry.”

The mistake the prof (if he is a prof) makes is that there will be boom times to begin with.

Who in their right mind will invest capital when they know the government is snatching a load of the profits, and where there’s no guarantee the government won’t take a bigger cut when it feels like it.

Companies and entrepreneurs will only invest capital if they believe the return will justify the reward.

All businessmen and women embark on a business in the full belief they have the nous to make money from it (unless it’s property investing of course, where the idea is to lose as much money as possible). Now, that isn’t to say that all will make money. Some will fail spectacularly. But the point is, they have the belief from day one that in the long run they can earn a buck from the venture.

And obviously some business ventures have more risk than others.

It’s pretty unarguable that opening a little coffee shop on Fitzroy Street here in St Kilda requires less capital investment, less risk and lower returns than someone exploring for gold or iron ore in the Australian outback.

But according to Mr. Freebairn, the return on a coffee shop in Fitzroy Street and a gold mine in Western Australia would be virtually the same, if as he suggests, miners’ Super Profits were taxed at “close to 100 per cent”.

Anyone with an ounce of grey matter can tell you that if the returns are the same or similar, it’s only natural that an investor will opt for the investment with the lowest risk of failure.

But aside from all this, there’s potentially an even bigger concern on the horizon. And that’s the impact government meddling will have on your retirement savings. But that reader, we’ll have to leave for tomorrow…

Cheers,
Kris.

“Property boom spurs spending spree” – The Age

“Big four banks gorge on house mortgages” – The Age

“Mortgage supply will not meet demand” – Banking Day

“‘Fair chunk of salary’ goes toward debt” – News Ltd

“Lending rates on way to boom levels” – News Ltd

Obviously if the Australian housing market was susceptible to the same risks as overseas housing markets then those headlines would set alarm bells ringing. Fortunately, as we’re told endlessly by the property spruikers, “Australia is different.”

So there’s no need to worry.

Instead, you can sit back, relax and follow other home borrowers that according to The Age are “taking out bigger mortgages to help fund the purchase of big-ticket items, from new cars to holidays.”

Thank goodness property is so productive. Because it will be able to pay off the new car and holiday without any effort at all.

Home borrowers just need to wait for the house price to rise further and then they’ve effectively bought the car and holiday for free. In a way, we suppose many home owners are just taking a leaf out of the central bankers’ play book.

They are monetising their debt. Printing dollars on the back of an home valuation by banks that are desperate to keep the bubble pumped.

It makes you wonder why people bother working when each home in Australia has a goose laying a golden egg in it every day.

But anyway, we’ve banged on enough about the housing bubble over the last two years, so we thought it was time we took a different approach.

I mean, not all property bulls and investors are spruikers. They invest in property because they truly believe house prices always go up and will continue to do so into the future.

But not only do many property investors have this rosy view of the property market, but they also have a negative view of the stock market. Why? Because of course they see the share indexes that fell 50% in 2008, and which are still a good 20% or more below the peak.

They also look at the same indexes and note that it’s barely above where it was five years ago:

Contrast that to a chart of the Australian Bureau of Statistics (ABS) price index of established houses in 8 capital cities:

One shows hardly any gain – ignoring dividends – while the other shows a 40% increase in five years.

And if we take the ABS numbers back another couple of years then the picture looks even better:

That’s almost a ‘doubler’ in less than eight years. To be precise, it’s a 90.5% gain with no discernable correction. As for shares over a similar period:

Well, actually that’s pretty good too. In fact, just using that chart we can claim that over a seven-year period from 2000 to 2007, share prices more than doubled. And for the ten-year period of 2000 to early 2010, share prices have gained by 66.67%.

So despite the risky nature of the stock market, and despite the 50% fall through 2008, share prices are still considerably higher than they were prior to 2004.

And naturally we should consider dividend payments paid by shares. Because unlike paper gains in housing – and even paper gains in share growth – dividend payments are actual cash payments being received by investors.

It’s money going straight into your bank account.

But does that mean share investing isn’t risky because the value doubled between 2000 and 2007? Does that mean share investing isn’t risky because the value gained 66.67% during the last ten years? And does it mean that share investing isn’t risky because the S&P/ASX200 has added nearly 60% in the last year?

Of course not. By anyone’s judgement share investing is risky. Anyone who tells you it isn’t risky should be ignored. And you should rightly label them a share spruiker.

Although if we were being devious, it’s possible for us to easily create an image of a risk free Australian stock market by simply cropping the above chart to look like this:

Ta-da. Like the ABS chart of house prices, there are a few ups and downs, but largely, over the five year period it would be easy to make the case that share prices always go up. Not only that, but they double every five years.

Presented with that evidence wouldn’t you be keen to leverage to the hilt as much as you can? Ask Storm Financial customers about their experience.

But knowing what we know about the stock market performance either side of that snapshot, we know that to claim stock prices double every five years would be quite misleading.

And here’s the thing. We also know for a fact that residential housing is just as risky as shares. There’s statistical analysis that tells us so.

But here’s something else we also know for a fact, residential housing comprises a much larger proportion of an individual’s asset base than share market investments. We can estimate that based on the total value of Australian residential property being over $3.5 trillion, while the Australian stock market capitalisation is around $1.3 trillion.

What else do we know? Well, as I pointed out in yesterday’s Money Morning, leverage can be super dangerous. Especially when you’re getting 100-to-1 leverage in the stock market through derivative instruments.

But, it can be super lucrative too. You can make a big return at the risk of making a big loss. I’m sure you’ve heard the saying about leverage being a double-edged sword.

And there’s little doubt that increased leverage helps to extend gains to levels that otherwise wouldn’t have been achieved, and conversely helps to extend losses to levels that otherwise wouldn’t have been achieved.

In other words, big leveraged positions in the stock market arguably helped push share prices lower than if there was no or less leverage.

You can get a good picture of that by looking at the Reserve Bank of Australia numbers on margin lending.

The numbers show that as of December 2009 there was $19.2 billion of margin lending outstanding on the Australian stock market. And that the lending was secured by over $53.9 billion worth of shares.

That’s in comparison to December 2007 when there was $37.7 billion of margin lending against $92.8 billion worth of shares.

But look at our cropped picture again:

And now consider the margin lending numbers for each December between 2002 and 2009: $10.7 billion, $12.5bn, $15.1bn, $19.8bn, $27.9bn, $37.7bn, $21.0bn, and $19.2bn.

In other words, the risk taken on board by investors grew as prices continued to rise. Sound familiar? Then what happened? Prices plunged and borrowers were forced out in a mad panic selling frenzy. Uncropped, the chart looks like this:

Doubtless by December 2010, margin lending numbers will have risen and more investors will be taking more risks.

Anyway, at the time we can estimate that margin lending by individuals accounted for about 2.5% of the total market capitalisation of the Australian stock market at the peak. Now, remember, the sole purpose of share investing is well, to invest money. Unless we’re otherwise mistaken there’s little other use for shares apart from as an investment. You can’t live in a share or eat it or wear it.

Now, before we go on, just remember what we’ve said. Investing in shares is risky. Investing in shares using leverage is risky. That the price of shares can fall as well as rise. And that leveraged share investments can have a bigger impact on the price of shares than unleveraged share investments.

We’ll make one other point before we continue. We’re not factoring in institutional investors here such as managed funds or hedge funds where leverage may also be used. We’re simply looking at individuals. Just to make that clear.

Now let’s take a look at something else. As I’ve mentioned, it’s known that the total value of Australian residential real estate is around $3.5 trillion. And we’re also told that there’s about 30% of home owners with a mortgage, about 30% without a mortgage and the balance is rented accommodation – a lot of which we’ll guess is mortgaged by landlords due to the tax benefits.

Well, according to the RBA, as of February this year there was $766.5 billion of lending against owner-occupied housing. And a further $326.8 billion against investor housing.

So all up you’re looking at nearly $1.1 trillion of borrowing by individuals against the value of homes. Or, in percentage terms, about 31.4% of the residential housing market is leveraged.

And to put it another way, housing borrowing is about 57 times greater than borrowing on shares.

What we can say from this evidence is that it’s crazy for property spruikers to decry the stock market as being risky without considering that Australian households on average have 57 times more leverage, and therefore 57 times more debt exposure to the housing market than to the share market.

Shares are risky. We concede that, and we’ve never denied it. However, we believe that property spruiking has made the Australian property market just as risky – in fact statistical analysis confirms that.

So whenever a property spruiker tells you how risky the stock market is, you should take note, because they are probably right. But what you should also take note of is their silence on the risk of housing.

So as we move full circle in this article, we come back to the beginning, and we look at those same five headlines again:

“Property boom spurs spending spree” – The Age

“Big four banks gorge on house mortgages” – The Age

“Mortgage supply will not meet demand” – Banking Day

“‘Fair chunk of salary’ goes toward debt” – News Ltd

“Lending rates on way to boom levels” – News Ltd

Should we still breathe a sigh of relief that Australia is different to the rest of the world? Or should we hold our breath in anticipation of perhaps the biggest property bust the world has ever seen?

Cheers,
Kris.

Not just because he thinks you may want a place to live, but because you’ll be doing your bit for your country.

He explains the role, “tax benefits for negative gearing plays in easing the current housing shortage and how it can help ordinary Australians build wealth for a safe and secure retirement.”

You see, when you build a house you’re actually helping to fix the “chronic” housing shortage. And you thought it was just so you had a nice place to live.

The housing bulls are feeling as strong as ever. Michael Pascoe wrote in The Age recently “House prices NOT tipped to slide.”

But what’s the other side to the rosy picture on property? Could there really be news stories such as the following within the next twelve months:

“Banks have launched action to take 707 properties, worth more than $200 million, in the past three months.”

“Homeowners are being served with repossession orders in some cases when they are only $2000 or just a few weeks behind in repayments.”

“HALF of all claims involved owners who had their homes for less than two years, and two out of 10 involved borrowers who had owned their home for less than 12 months.”

“BORROWERS who don’t pay on time are being charged penalty interest, double the original rate. Some are being charged 20 per cent on loans and default rates of up to 40 per cent.”

“The average loan being called in was $244,000, on which repayments have risen by $460 a month…”

“A loan of this size, taken out at today’s average rate of 8.95 per cent, would cost an extra $138,000 in interest over 25 years…”

“Homeowners have told of repayments rising above their income and financial stress leading to ruined relationships.”

“Former Croydon homeowner Rodney said he was just $3000 behind on his mortgage when he found the locks had been changed by his bank.”

Is it really that far-fetched to picture mortgage interest rates climbing to nearly 9% compared with the 5.5% or so today? Maybe it won’t be next year, maybe it will be the year after, or the year after that.

Well, the quotes above are taken from Melbourne’s Herald Sun in February 2008. That of course was near the end of the Reserve Bank of Australia’s period of increasing interest rates.

When interest rates were at the previous record low, mortgage rates were a similar level to today’s rates. Then from mid 2002 until September last year interest rates climbed until reaching a peak of 7.25%.

But even between mid 2002 and the end of 2003, interest rates climbed by 0.75%.

Can it be guaranteed that interest rates won’t follow a similar path by the end of next year? No, of course it can’t. And if you look at how the bond market is trying to push rates higher even as the RBA is keeping them artificially low, it is obvious that mortgage rates are set to rise.

I’ve printed the Aussie yield curve again below. Even in the last week, rates at the short end (3 months) have increased by 0.05%.

But look again at the average loan size quoted in the Herald Sun article – $244,000. That’s significantly below the average loan commitment being made by first home buyers now. According to the recent Australian Bureau of Statistics (ABS) numbers “the average loan size for first home buyers fell $2,500 [from the previous period] to $283,400.”

Still, that’s over 15% higher than the average loan default during 2007/2008.

There can be no doubt at all that current actions in the Australian housing market are helping to prop up house prices. The danger at the moment is to think that either the propping-up has ended or that the worst is over.

Both assumptions are wrong.

We’ve even put our reputation on it by tipping a real estate investment trust in Australian Small Cap Investigator on the assumption that misplaced bullish sentiment on property will last at least through to the end of this year.

And don’t forget, not only has the Federal government extended the first home buyers grant, but State governments have raised the bets too. First home buyers in regional Victoria will qualify for $36,000 to put towards buying a home between July and September.

And now second home buyers in New South Wales will get a stamp duty reduction until the end of this year.

Eventually, as with all bubbles, the inflow of funds cannot be maintained, and the crash occurs – usually when investors think the worst is over!

To put it in context, a $283,400 home loan today at 5.74% means a monthly repayment of $1,782. Should the rates increase to 8.95% the repayments go up to $2,369 per month, or nearly $600 extra per month.

That’s about an extra $850 per month of before tax income, or not surprisingly, $10,200 per year of before tax income, which will eat up an extra 17% of an average Australian’s salary – assuming they are in a single earning household.

So, even if we believe that people will do all they can to keep hold of their home rather than allow it to be repossessed, rising interest rates will clearly have an impact on the economy.

Hence your editor’s concern in Tuesday’s Money Morning about businesses being encouraged to spend up on capital goods now when chances are in twelve to eighteen months time the investment in capital goods will have been wasted as the consumer is unable to purchase the goods being produced.

What does that tell you about the outlook for the economy going into next year?

Other Stuff on the Markets

The S&P/ASX200 0.24% yesterday, while on Wall Street with the Dow Jones Industrial Average slipped 23 points. In Europe the FTSE100 and CAC40 gained 1.18% and 2.18% respectively.

The price of gold in Australian dollars is trading at $1,168.38, while in US Dollars it trading at $931.30.

The Aussie dollar steadied versus the US dollar and Japanese Yen, trading at USD$0.7963, and JPY76.23.

Crude oil closed at USD$68.27.

For the biggest movers on the market yesterday click here…

And today on the economic calendar we have in the US, GDP, initial jobless claims and personal consumption numbers.

Cheers.
Kris.