The stock paradox

Strange world we live in now. Over in the US the Bureau of Labor Statistics reported here the non-farm payroll data:

"Nonfarm payroll employment increased by 175,000 in May, and the unemployment
rate was essentially unchanged at 7.6 percent".

So the US continues to add jobs. Here's the seasonally adjusted chart:

Source: Bureau of Labor Statistics

The participation rate was also fairly steady, ticking up 10bps to 63.4%. Not too shabby overall. "Decent enough" one might say.

Here's the chart of the US unemployment rate:

Source: Bureau of Labor Statistics

The unusual thing about the interpretation of the data is that stock market analysts and institutional investors had feared that a drop in the unemployment rate could see an end to the Fed's stimulus program.

Christopher Joye over at the AFR, who always has a nice way with words, refers to 

"Ben Bernanke’s  tautological statement that the Federal Reserve will have to wind back its 

$85  billion a  month money printing program if US conditions continue to improve."

A moderate increase in the headline rate of unemployment to 7.6% ensures that, for now at least, this won't be the case. The Bureau calls this "essentially unchanged" and they are probably right, as the trend still appears to be down.

The US markets went on a field day, with the Dow adding more than 200 points in the trade.

Bad news can be good news: the strange new world of quantitative easing we live in.

In Japan the Nikkei 225 Index ran all the way up from 8,328 to 15,942 in the past 12 months, before investors got scared and triggered a correction.

The tremendous shot in the arm for stock valuations was Japan's own stimulus program. The economy has been in the doldrums for so long that drastic action was taken, and investors fearful of raging inflation piled into stocks with valuations doubling accordingly in just one year.

Note that, just as in the US where stock valuations have roared up well over 100% since 2009, there is very little emphasis here on fundamentals or the strength of the economy. Moreover, hot money seeking returns simply flies into the market.

The upshot of this phenomenon will likely be volatility. That is, sharply rising stock valuations where quantitative easing is undertaken followed by sharp corrections when the stimulus is taken away.

Australia

In Australia, the stock market has never quite recovered with the same fervour since 2009, perhaps partly hampered by our strong dollar.

We have seen an element of the 'bad news is good news' in property markets though. 

As the world's economies crumbled from 2007-2010, there was something of a feeling of "the worse the world gets, the better Australian property will" and low interest rates fired capital growth up until 2011.

This led some foolish commentators to state that they "can't wait for the next global financial crisis". 

Quite apart from being an unpleasant and facetious thing to say, this is also hopelessly naive. The mistaken attitude showed itself again in late 2012 as the cash rate was cut with plenty of misguided celebration by property investors. 

Yes, lower interest rates are good, but you also need to consider why the cash rate has been cut so low - it corresponds to slower economic growth and thus a heightened risk of recession.

While low interest rates can sometimes cause a property price boom, this is by no means always the case. Just ask people in Britain or the US.

Ultimately, over the long term countries need a strong economy and growing wealth to justify higher asset prices.

Mark Bouris of Yellow Brick Road stated this week that "over the next 5 years Australian property will be the hottest asset class you can possibly think of".

Is he right? That will be the subject of my blog post later today...

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Will property be the hottest asset class for the next 5 years?

Mark Bouris caused a bit of a ripple this week by suggesting that the Australian property markets will represent for the next five years "the hottest asset class you can possibly think of".

Of course, just as a hairdresser is probably not the best person to ask if you need a haircut, so it is in this instance, but is Bouris likely to be right?

Some economists, such as David Bassanese of the AFR have made similar suggestions, implying that prices are likely to "pop higher" at this stage in the cycle. 

Bouris bases his theory around past experience in Australia. Property downturns, such as the one we experienced through 2011 and the first half of 2012, can be followed by lower interest rates, significantly improved affordability (read: mortgage serviceability) and a surge in real estate prices.

Is this time any different?

Remember the classic old exam question: "does history repeat itself?". The textbook answer is, well, yes to some extent, but the specifics tend to shift. And there is much evidence to suggest that this cycle may be somewhat different from those we have seen in the past.

1 - Deposit growth

Firstly, there is an argument to say that there will be restrictions on credit growth in this cycle, as the prudential regulatory body APRA looks to cap the growth of credit in line with deposit growth.

One complicating factor is that from the middle of 2012, the Australian stock market boomed by around 25% in value increasing Australians' wealth. Of course, articles began to appear of "the best year for superannuation in ages" type, which naturally pre-empted a correction of close to 10%.

Nevertheless, stock valuations are up, can increase cash available for deposits, and superannuation balances are up too. Self-managed super funds can invest in property these days, but lenders to SMSFs tend to insist on substantial deposits, so most of that action will likely be in the lower-median sector of the market, particularly in apartments.

2 - Higher household debt

More significantly, Australia commenced this property cycle with higher household debt levels than it had previously. When interest rates fell around in the early 1990s, credit growth boomed. Consequently, it seems unlikely that another boom of such a magnitude could occur. 

Future growth, therefore, is likely to be far more closely correlated to growth in household incomes. 

And in fact, in Sydney, since the last boom period through to early 2004, household income growth has outperformed property prices for close to a decade.

3 - Access to credit

A third limiting factor is that in the period preceding the last surge in dwelling prices, there was a proliferation of 100% LVR loans available, which is not the case today. 

Whether or not such a cavalier lending sentiment returns remains as yet unknown, but it seems to me that over the long term it would be better for everyone if an appropriate level of prudence was exercised in this regard.

Multi-speed recovery?

Plenty of commentators have focussed on RP Data's Daily Home Value Index and noted that "house prices fell in May" and plenty of scorn has already been heaped on Bouris by bearish commentators in the last few days.

But those figures are retrospective; what for the future?

There may be something to draw from the May figures, but most other indicators such as lending finance figures from AFG (reporting "unprecedented mortgage sales") and from the ABS, suggest something of an uplift in market sentiment.

Other indicators seem to suggest improving sentiment too, although not across the country.

There is much evidence to suggest that property prices in Perth are considerably higher than they were 12 months ago and the market has not demonstrated many signs of slowing down just yet.

Meanwhile auction clearance rates in Sydney, and to a lesser extent Melbourne have improved strongly. In Sydney's inner west, clearance rates are consistently clocking at around 85% or above, which is the sign of a hot market. Sydney's North Shore looks strong too.

However, it's not all good news for property owners and investors, for to date the recovery seems to have been largely investor-led. For this reason, I don't expect remote property markets and outer fringe suburbs to have much joy as this cycle progresses.

The RBA's chart packs show that households on average seem quite content to save 10% of  disposable income, which was not the case after interest rates fell from the early 1990s.

Not buying now?

I've never been a big fan of the "Don't Buy Now" rhetoric, for it implies that homebuyers can easily outsmart the market through using clever timing. It's possible to do, of course, but it's also by no means assured.

Those who took Steve Keen's advice to sell their homes in 2008, for example, must be mortified by the subsequent uplift in capital city prices over the last half decade.

Ideally, homebuyers should be putting their focus on a far longer time horizon than the next few years.

However, as noted by my Pommie pal Catherine Cashmore of NPB, with people moving house more frequently than previous generations ever did, even homebuyers are now buying homes with an "investor mindset".

They want a  roof over their head and capital growth, and for this reason often look to steer away from the remote or new fringe suburbs where demand is low and new dwellings can show poor or non-existent growth.

As for investors in property, this cycle seems likely to produce lower growth on average that we have seen in times past.

For this reason the old strategy of simply 'buying in your own backyard' because that's what you know best may be a poor strategy.

The hot sectors of the market at this stage look to me to be certain suburbs of Perth and as noted Sydney's Inner West and North Shore, particularly in the sweet spot price range of $500,000 to somewhere just over $1 milllion.

Yield-focussed investors will of course continue to dispute the obvious evidence below that it is investors which are pumping up prices in inner- and middle-ring suburbs, but the RBA's chart pack clearly shows that regional market growth in most areas stalled years ago with few signs of life to date. My own money is on inner- and middle-ring Sydney.

DYOR.

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