The Real Cost of Massive Debt and Cheap Money

The TV in our building’s gym is not long for this world.

The salt-water mist has corroded the components.

We have one station with sound.

Yesterday morning, there I was pedalling away on a bike. The presenters on TV started talking about the unaffordability of the Sydney property market. My interest was aroused.

The headline statement went something like:

‘Weekly house price increases are greater than what the average person earns in a week.’

Followed by:

‘People will never be able to afford to buy a first home in Sydney.’

That’s typical one-dimensional thinking…prices will keep going up.

They did not discuss any of the other variables in the equation. It was another case of extrapolation…what has been will continue to be. A classic mistake at the peak of a market.

As further confirmation that the Sydney and Melbourne property bubbles are close to bursting, we need not look any further than the brains trust in Canberra.

The government remains open to a controversial increase in capital gains tax as part of dramatic move in the May budget to tackle housing affordability, as backbenchers step up calls for action despite Malcolm Turnbull’s warning last week against the change.

The Australian, 19 February 2017

The government is always late to the party. They always want to tax something at precisely the wrong time.

Remember our tin-badged former Treasurer Wayne Swan announcing the ‘Resource Super Profits Tax’ in May 2010?

The tax was to take effect on 1 July 2012. Swanny needed to plug the big, black hole he and Kevin Rudd created after their reckless GFC cash splash.

What was the big earner back then? Mining. The boom was in full flight.

Swanny’s grand plan was to grab 40% of the ‘super profits’.

When was the iron ore price peaking?

You guessed it: 2010/11.

iron ore price

Source: Trading Economics
[Click to enlarge]

But let’s not beat up too badly on the hapless Swanny. A government coming in on the cusp of a turning trend is not a new.

Over the past six months, the Reserve Bank has sold 167 tonnes of gold, reducing its holdings from 247 tonnes to 80 tonnes.

Reserve Bank of Australia Statement, 3 July 1997

Apparently gold was no longer considered the insurance it once was:

Central banks traditionally hold gold because of its ability to be used in the event of a crisis in the international financial system; it is the only reserve asset that is not a claim on some other government, international institution or bank. However, over the past two or three decades, the world has experienced a number of economic “crises”, but gold played no part in coping with them…

When did the RBA sell?

A couple of years before the gold price proceeded to rise nearly sevenfold in value — US$280 an ounce to US$1,900 an ounce.

gold price

Source: Trading Economics
[Click to enlarge]

These are examples of ignoring Herbert Stein’s Law: If something cannot go on forever, it will stop. Herbert Stein was the chairman of the Council of Economic Advisers to US Presidents Nixon and Ford.

In the case of Swanny’s tax grab, all he had to do was ask whether China could continue to borrow and spend like a drunken sailor forever and a day. The answer was clearly ‘no’.

In the late 1990s, the price of gold had been on a downward trend for nearly two decades. Gold was trading at a price that basically reflected the cost of extraction. Could this trend continue?

The same goes for Sydney and Melbourne property prices. Everyone stands back, watching and wondering about how much further prices can go into the stratosphere.

What about the prospect of prices returning to Earth?

We didn’t consider that option. Could that really happen? That hasn’t been the trend.

Why can’t it happen?

Apparently there’s a land shortage — created by local government red tape — pushing up values.

Yes, this supply bottleneck could be a contributing factor, but it is not the main driver.

Foreign investors?

In last week’s Markets and Money, I revealed Treasury figures showing that foreign investors have had a minimal impact on values.

What’s the primary driver? I’ll explain.

Cheap money, expensive housing

Let me put this scenario to you.

If home loan interest rates were at 10% instead of 3%, do you think people would be able to borrow as much money and, in turn, bid home prices up to the level they are currently at?

No, they wouldn’t.

Therefore, through a process of elimination, we can deduce that the fuel driving property values up is access to cheap money.

With banks having to source around one-third of their funding from offshore markets, what happens in international bond markets becomes relevant to domestic borrowing costs.

If bond rates resume an upward trend, Aussie home loan rates would go up too. We would then start to see defaults, as highly leveraged households start selling up.

Asset values are a function of a multiple applied to earnings. There is a degree of elasticity — expansion and contraction — in this equation.

However, the elastic band does not stretch forever…it snaps back.

To highlight how this dynamic works in real life, I’ve included an extract from my book, ‘How Much Bull can Investors Bear?’ here:

Here’s the share price chart of Walmart since the company listed in 1972.

Walmart share price

Source: Yahoo Finance
[Click to open in a new window]

Look at the spike in the share price from late 1996 to late 1999 — US$10 to US$70.

Even the pricing of boring old Walmart shares was caught up in the euphoric social mood created by the dotcom boom.

In 1999, Walmart had earnings per share (EPS) of US$0.99 (let’s round it up to US$1).

The share price peaked at US$70. Therefore, the price (US$70) to earnings (US$1) ratio was 70-times.

Cast your eyes to the right of the chart and you’ll see that nearly 17 years after the dotcom peak, Walmart’s share price is a little over US$70. The share price has virtually stagnated.

But what’s happened to Walmart’s earnings?

Walmart’s latest company report states that EPS is at $4.64. A fourfold increase from 1999…yet the share price has gone nowhere.

The current price (US$72.35) to earnings (US$4.64) ratio is…wait for it…15.6…the long-term market average P/E.

The gravitational pull of ‘reversion to the mean’ eventually works its way through the market…even for the bluest of blue chips.

Even though earnings have increased fourfold, if the multiple applied to those earnings decreases by the same factor, it’s a zero-sum game.

This is an example of the heart ruling the day in the mid to late 1990s, and then the head applying a more realistic value over a longer period of time.

The P/E multiple is a reflection of the social mood…which is why it’s important to recognise the impact emotion plays in determining asset prices.

In good times, the multiple will be higher and, conversely, in bad times it’ll be lower.

At present, the heart is ruling the head when it comes to Sydney property values. People are caught up in the trend.

With the average property price in Sydney 12 times higher than the level of annual household earnings, where to from here?

Can the multiple double to 24 times? Only if loan interest rates go to 1%.

Can household incomes rise substantially? Possibly, but this seems unlikely in a world where billions of people have a daily pay rate equivalent to what we in Australia pay for a coffee. And don’t forget that other job killer…automation.

If the multiple applied to household earnings is stretched to its limits, and household incomes do not rise significantly, the best case scenario is for property values to stagnate…on the proviso interest rates don’t move too much.

Alternatively, the multiple reverts to the mean and prices fall around 30%.

Not possible?

Well, it happened to Walmart…the biggest retailer in the world. So what makes us so smug to think we are immune from the universal law of mean reversion?

It’s this smugness that’s setting us up for a fall. We are not special. We do not have unique factors driving our market.

We have overindulged on debt and deluded ourselves into thinking we are different.

We are no different to any other country that’s tried to buy its prosperity with an excess of borrowed capital. This will all end in tears.

In two years’ time, my guess is that the talking heads will be asking the question, ‘How much further can prices fall?’

Hopefully, by then, our body corporate will have purchased a new TV so I can watch something far more informative…like the Sunday morning cartoons.


Vern Gowdie,
Editor, Markets and Money

Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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