Amid the recent emergence of rising prices, all the talk of bubbles in stocks or in property is simply premature. We'll leave US Treasury bonds and the US Federal Reserve out of this discussion until the Postscript and focus on Australia for now.
That is not to say that prices will not decline. They may fall, but any drop from current levels would not be due to the presence of a bubble, nor evidence of it bursting.
But I do believe the first seeds of a bubble have germinated and it is also true that bubbles already exist in some individual stocks and sectors. It may be some time before a true bubble – one marked by contagion that is damaging to markets, investors and the broader economy – emerges, and it may be the case that no potentially damaging bubble develops at all.
Bubble definitions
To discuss both shares and property in the context of bubbles, it is first worthwhile to define them.
The Canadian and later U.S. economist and diplomat, John Kenneth Galbraith, in his book The Great Crash observed:
“…at some point in a boom all aspects of property ownership become irrelevant except the prospect for an early rise in price. Income from the property, or enjoyment of its use, or even its long-run worth is now academic. As in the case of the more repulsive Florida lots [in a mid-1920s land boom], these usufructs may be non-existent or even negative. What is important is that tomorrow or next week, market values will rise—as they did yesterday or last week—and a profit can be realized…”
Stewart Robertson of Raine & Horne Real Estate recently sold a block of five flats in Mosman, on Sydney's north shore, for $3.52 million on behalf of a couple who had purchased the property at the depths of the GFC in 2009 for $2.9 million. The block contained one 3-bedroom apartment, two 2-bedders and two 1-bedders. The gross rent was just $139,000 a year. The new buyer will have to subtract maintenance and other costs, fees to a property manager and tax before a net yield is available. If more than 50% of the purchase price was borrowed, you can be sure there will be no income return available.
John Galbraith was referring to income, or the lack thereof, from vacant Florida swamp land, but the reference is equally valid for the Mosman block of flats.
Damaging and debt-driven
Back in 2010, I wrote in my blog:
“a bubble guaranteed to burst is debt-fuelled asset inflation; buyers debt fund most or all of the purchase price of an asset whose cash flows are unable to support the interest and debt obligations. The bubbles to short are those where monthly repayments have to be made.”
And in his book The Map and the Territory: Risk, Human Nature and the Future of Forecasting, former US Federal Reserve Chairman Alan Greenspan goes further, distinguishing a bubble whose bursting causes widespread damage from one that doesn’t:
“The crashes of 1987 and 2000 had comparatively minimal negative effect on the economy. The severity of destruction caused by a bursting bubble is determined not by the type of asset that turns 'toxic' but by the degree of leverage employed by the holders of those toxic assets. The latter condition dictates to what extent contagion becomes destablising. In short, debt leverage matters.”
With bubbles properly defined as those that are debt-based, contagious and damaging when they burst, it may be prudent to apply the definitions to both the Australian stock and property markets.
In Australian stocks there are a few signs of elevated prices. At Montgomery we first define companies according to a quality score; A1 companies have the lowest risk of catastrophe between now and the next reporting period. Companies with a C5 rating have the highest risk. We will only invest in companies that score A or B and 1 through 3. That means companies rated A4, A5, B4, B5 and C1, C2, C3, C4 or C5 at the time of possible acquisition will generally not find their way into The Montgomery Fund, irrespective of whether they are cheap or not.
If we put aside this test, we can rank the largest 100 Australian companies (we can rank every listed company in the world, see skaffold.com) by their discount and premium to our estimate of their intrinsic value. If we apply this test, we discover that at the time of writing just four of the top 100 companies show a discount to intrinsic value. If only four companies are cheap, it suggests 96 companies are expensive.
Over the last three or four years, when I have observed this discounting, the market has ceased rising and in fact, in most cases, it has subsequently fallen by between 5% and 15%. Once again, I am not predicting the start of a sell-off, nor the presence of a bubble, but it does seem that prices are not currently justified by valuations.
However, I should point to the existence of one of several ‘mini bubbles’ at the moment, although the impact will be quarantined by their microscopic size. Since mid-July 2013, the share prices of several small technology companies have been riding a wave of optimism, buoyed by digital communications industry buzzwords such as ‘cloud’, ‘mobile’, ‘payments’ and ‘online scale’. The share price trajectories have left us shaking our heads.
Suppose we offered you the opportunity to buy a diversified digital ‘business’ for $292 million. If, upon telling you that the business generated just $16.9 million in revenue and made a loss in 2013 of $4.1 million, then if you didn’t zip up your wallet and run, you would arguably need your head read. Combine the current market capitalisation, revenue and profit for the companies SmartTrans, Mobile Embrace and Mint Wireless and you have exactly that scenario.
Paraphrasing Galbraith, all aspects of ownership have become irrelevant except the prospect for an early rise in price. Income from the businesses, or even their long-run worth, is now academic. What has become important is that tomorrow or next week, market values will rise—as they did yesterday or last week—and a profit can be realised.
Property worries
When it comes to property, it appears a slightly different ingredient is emerging that could be more damaging if permitted to inflate further.
During the GFC, many homeowners, some of who are reading this article today, found themselves unable to offload their multimillion-dollar abodes. Even in exclusive and popular Mosman, entire streets where ‘quietly’ on the market. Properties purchased for $10 million to $15 million couldn’t find buyers at $8 million. The impact was felt most acutely by those whose financial obligations were reliant on continuing bonuses that failed to repeat previous excesses. The wealthy, however, largely represented the boundary of the fallout.
Today matters are quite different. Low interest rates have served to encourage buyers in the broader market to acquire homes at every price point, but low interest rates and generous borrowing terms - you can obtain a fixed rate mortgage for 4.8% with 100 per cent gearing, 70% in your super fund – have meant that many will overextend.
By way of example, Bloomberg finance reporter Narayanan Somasundaram wrote, in an article entitled, Australians ride housing with pensions not so super:
“Howard Kindler, 57, dipped into his pension to turn property investor, spending a third of his retirement savings and taking out a mortgage to buy a Melbourne apartment.
Disappointed with the returns of his retirement fund, Kindler is one of the million Australians who go it alone and manage their own pensions, known as self-managed superannuation funds or SMSFs that together hold A$500 billion ($US474 billion) in assets. Many are increasingly banking on surging home prices to provide a comfortable retirement, and like Kindler, are leveraging their investment, expecting higher returns.”
Remember Alan Greenspan’s observation: “The severity of destruction caused by a bursting bubble is determined not by the type of asset that turns 'toxic' but by the degree of leverage employed by the holders of those toxic assets.”
The Reserve Bank noted back in September: “Property gearing in self-managed superannuation funds was one area identified where households could be starting to take some risk with their finances.”
To be fair, housing supply is one thing we don’t have an excess of. When visiting New York and Florida in 2007, I was struck by the billboards that urged Americans to buy a house and get one free. And this was before the US economy went pear-shaped. Until 2007, low interest rates in the US led to a boom, not only in house prices, but also residential construction. A subsequent supply of excess stock combined with the rolling over of sub-prime loans from interest-free periods triggered a collapse, as home owners were no longer able to support the mortgages that had been propping up house prices.
Germinating not bubbling
In Australia we don’t have a bubble in stocks or property yet, but we do have a couple of the key ingredients that if left unchecked could help fuel a bubble.
In property the germinating ingredient is that everyone believes they can become rich, or safely retire, through buying property. Low interest rates and the fear of missing out may just encourage enough buyers to borrow too much, supporting house prices rising to elevated levels that prove temporary.
In stocks, there’s no bubble in the broader market either, although there are examples in certain sub categories. However the overall market does appear expensive, given that just four companies in the top 100 reveal any hint of a discount to our estimate of intrinsic value.
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Postscript: key policy shifts overseas?
As we are on the subject of stocks and bubbles, it’s worth adding a postscript that ties this discussion to developments in the deep dark corners of the US Federal Reserve.
One of the conversations occurring in the halls of global central banks — but not being reported in the Australian press — is whether the Fed is about to embark on a ‘regime change’, by which I mean a very serious shift in policy.
When European Central Bank President Mario Draghi infamously pronounced in just seven words, that the central bank would do "whatever it takes to preserve the euro," he signalled a massive regime shift at the central bank. And it worked.
When Japanese Prime Minister Shinzo Abe replaced both the Governor and the two Deputy Governors of the Bank of Japan and committed to setting ambitious targets for inflation by engaging in quantitative easing on a massive scale, he signalled to the world and its officials that to get something done, you really need to ‘move the dial’.
The US is looking at this in the context of a study that found since January 2009, the New York Stock Exchange rose every week the Fed bought bonds and fell every week it didn't.
The idea of fuelling a bubble may be gaining momentum.
We all know that the US economist Janet Yellen is taking the Chair at the Fed, and she has said that targeting inflation will play second fiddle to ensuring healthy employment. And the US central bank is widely regarded as having been unsuccessful in its policy settings as they relate to unemployment.
Christina Romer, who was head of Obama's Council of Economic Advisers from January 2009 to September 2010 and a worldwide expert on the Great Depression, may replace Yellen as Vice Chair of the US Federal Reserve. Christina Romer aligns with Yellen in that she forcefully supports the idea that withdrawing stimulus too early threatens a 1937-type economic reversion, and she believes that economic growth can be improved by changes in expectations on growth, and that if the Fed turns its focus to targeting nominal GDP, it can achieve its aim.
In a speech entitled "Monetary Policy in the Post-Crisis World: Lessons Learned and Strategies for the Future" that she gave on 25 October 2013, Christina Romer said:
"A final way beliefs may be important involves expectations of growth. People's expectations about the future health of the economy have a powerful impact on their behavior today … If a central bank through its statements and actions can cause expectations of stronger growth, that can be a powerful tonic for the economy … for policymakers to really move the dial on expectations and push them firmly in the direction they want them to go — it takes a regime shift. Smaller, more nuanced moves are easily missed or misinterpreted by people in the economy.
“Back in 2011, a number of economists, including me, argued that the Federal Reserve ought to adopt a new operating procedure for monetary policy: a target for the path of nominal GDP … Switching to this new target would have some important benefits. In the near term, it would be a regime shift. It would unquestionably shake up expectations. Since we are currently very far below a nominal GDP path based on normal growth and inflation from before the crisis, it would likely raise expectations of growth, and so help spur faster recovery …
"Today, I worry that guilt over letting asset prices reach the stratosphere in 2006 and 2007 has made some policymakers irrationally afraid of bubbles. As a result, they focus on the slim chance that another bubble may be brewing rather than on the problems we know we face — like slow recovery, falling inflation, and hesitancy on the part of firms to borrow and invest."
As I mentioned at the beginning of this article, we are not in a bubble … not yet, anyway.
Roger Montgomery is the Chief Investment Officer at The Montgomery Fund, and author of the bestseller, ‘Value.able’.