Bubbles, Busts and Income Stocks

Last week was a strong one for global financial markets. Stocks had their biggest rally in nearly two years. On Friday, the Dow and S&P 500 put on nearly 1%. Our market was off to a good start early in today’s session, with the ASX 200 aiming for its first close above 6,000 since 2008.

But this level looks like an important one for the market and will offer a bit of resistance. It might take a little while to clear. Once prices do breach 6,000 points for a few days or a week, there’s a good chance you’ll see record new highs in the following months.

The US Federal Reserve was behind last week’s market rally. In a sign of just how ‘dovish’ the Fed is, the market assumed that interest rate tightening would begin sooner rather than later. It’s not often the market overestimates the Fed’s willingness to tighten.

But the Fed’s statement and press conference assured them that wouldn’t be the case. And a rate rise in the US will be later rather than sooner.

The Fed has moved the goalposts on a number of occasions in its desire to ‘normalise’ interest rates. This normalisation process has been going on for years. I remember the Fed first started talking about it back in 2010…that was before QE round two and three and ‘Operation Twist’!

And back in 2013, the then Governor, Ben Bernanke, discussed the process of normalisation from years of QE. Here we are two years later, still waiting.

The Fed initially targeted the unemployment rate as its guide to know when to lift interest rates. But now that employment growth is strong, the Fed has moved its focus to inflation. Of course, thanks to crashing oil prices and general deflationary conditions, inflation is not a concern right now.

With inflation not a worry, the market realises it’s got much longer to speculate than it previously thought.

Last week showed you that there will always be a reason for the Fed not to tighten. Low inflation…a strong dollar…economic growth not robust enough.

Needless to say, history will not look kindly on the US central bank. Slowly but surely, it’s sending the world down the path to another 2008 type crisis. It’s encouraging speculation and debt accumulation on a scale never before seen in history.

When the next crisis hits, it will be much, much worse than in 2008. Governments will have no ammunition to get us out of trouble. They’ve spent the past seven years firing it.

The problem is, no one knows when the next crisis will hit. All I can say is that at the moment, there is no immediate sign of it. Certainly not in Australia…

On Friday, two top bureaucrats stoked the fires of future financial instability in this country.

RBA boss Glenn Stevens indicated that interest rates might fall further. At the same time, APRA (the bank regulator) head Wayne Byers voiced concern about the effect of low interest rates on house prices…but he still isn’t too keen to do anything about it.

Well, he did write a letter to the banks in December telling them to go easy on the lending. That’s had zero effect. His next weapon is imposing stricter capital requirements on individual banks if he thinks their lending practises are getting out of hand.

But that may or may not happen and even if it does, no one will know about it because Byers’ policy is to not publicly disclose that a bank has been overdoing it and needs disciplining.

Apparently, such disclosure (of the truth, I might add) could undermine the integrity of the financial system! Are these guys serious? You’ve got Stevens’ in one corner blowing bubbles in Sydney and Melbourne real estate markets and Byers in another saying it’s all good…and even if it’s not, no one should know about it.

This type of regulatory neglect beggars belief.

Unlike the Fed, maintaining financial stability is one of the RBA’s mandates. Surely then it can see that it’s contributing to a massive amount of long term financial instability with its current policies?

House price booms always end in busts. It’s just a matter of time, and Australia is no different. However, our recent experience is different from most other nations.

That is, we’ve had the benefit of a long secular decline in interest rates from a peak of around 17% in the early 1990s to 2.25% (and heading lower) now.

At the same time, we had two massive terms of trade booms. The first one lasted from 2002 until 2008. The second one was shorter but bigger, lasting from 2009 to 2011. These provided a massive injection of money into the economy, money that we gratefully borrowed against to speculate on real estate.

The result of all this is a massive house price boom, now narrowly concentrated in the main markets of Sydney and Melbourne. There’s no reason why it can’t keep going for another couple of years either.

While ever Stevens keeps pushing the interest rates buzzer, Byers looks the other way and the government refuses to address the tax distortions that encourage capital to pour into property, prices will march higher.

But the gains will only accrue to speculators or those who have been in the market for years. It’s these players who can leverage up their increased housing equity to push prices up even further.

There’s nothing wrong with this at an individual level. People are just responding to price signals. But at an aggregate level, it’s disastrous. Apart from creating a huge boom that will turn to a bust when the stimulus runs out, it’s also creating increased social tensions as Australian society fractures between the haves and have nots.

And when the bust hits, that’s when those tensions will boil over. It’s all well and good to have a boom and economic ‘good times’. But when it’s a boom created out of easy money, the ‘good times’ never last.

Despite history teaching this lesson over and over again, we appear doomed to ignore it. Human hubris knows no bounds.

So what can you do to survive?

The first thing to do is acknowledge it. Know what’s coming down the pipeline so you’re at least partly mentally prepared for it. Most wont be.

Second, realise that it will probably be slow to materialise. That gives you time. So if you want to join in and take advantage of the Fed’s and the RBA’s insanity (while occasionally despairing at it), do it now.

One thing is for sure: interest rates are staying low for some time. If you want income generating ideas in such an environment, keep an eye out for a new income product we’re launching this weekend called Total Income.

I’ve asked Total Income editor Mat Hibbard to contribute to Markets and Money this week and introduce you to some of his income generating ideas.

Greg Canavan,
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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