Recent comments from the Reserve Bank of Australia suggest an impending boom in house prices. Australian house prices have weathered the global financial crisis quite well, with the Home Loan Affordability Index in chart 1 remaining at low-medium levels despite a sharp reduction in interest rates.
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A “double wammy” is now waiting in the wings if house prices do rise as this will put further upward pressure on interest rates – the RBA has signalled that it does not want to see runaway property values as this typically hurts the lower end of town. Rising prices combined with increasing interest rates would see affordability go to new lows on the chart above. The last two sentences may seem to contradict each other. However, affordability would be worse still for lower income earners if prices were left unchecked, while in comparison wealthier households would likely benefit via existing exposure to property.
But how long can such a state be maintained? There are quite a number of observers suggesting that Australian house prices are a long-term bubble waiting to burst. While I am not convinced of such a gloomy outlook, housing in most other developed countries is now at much more affordable levels.
This becomes interesting when looking at what may happen next in terms of the economy and, more importantly, equities. Now I certainly don’t pretend to have a crystal ball, but looking at previous bear markets and recessions can help us form a picture of what might happen.
Going all the way back to the banking crisis of 1907 first of all, we can see that the Dow Jones managed almost straight line gains back to the previous high before falling away to a low in 1915. This in effect created a large sideways movement that preceeded the huge run into 1929.
Chart 2 – Dow 30 from 1900 to 1950
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Next we see the Dow Jones in the period from 1970 to 1990 (roughly). In a similar fashion, the market managed to claw back its losses quickly and almost without rest after the initial crash, before again continuing sideways into the 1982 low.
Chart 3 – Dow 30 from 1970 to 1990
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I concede these are only two examples and there is no requirement what-so-ever for the market to follow either path. It does remind me however that after a large fall markets will often experience a period of range trading, albeit large range trading in the 1970’s case.
The question of what may spark further falls has many answers. One, especially in terms of the Australian market, returns us to the topic of house prices. A correction there could spark a new wave of fear regarding the economy and translate to falls in equity prices. We certainly saw what that can do in the US recently.
However, the bulls still have a number of positives up their sleeves in the near term. One is that, as I’ve mentioned previous, few people are brave enough to be openly and unconditionally bullish. The majority of opinion still seems to be the market is ahead of itself and is due for a pullback. As Laszlo Birinyi would say, “the market is always ahead of itself!”
That current tone is mainly due to the fact that most retail investors have missed the current move and are looking for every possible reason as to why the market will give them another chance. Combine this with the fact that media likes to push the negative case because it makes for better headlines and there you have one feeding the other’s bearish sentiments in a loop.
That loop will eventually be broken by either the market falling significantly or trading high enough that (for most) greed and the fear of missing out take over. I am betting on the latter, which would almost certainly mark the start of further falls.
The sixty-four thousand dollar question is at what level does the fear of missing out take over? No doubt time will tell. In the mean time, it does appear to be a good time to have exposure to both equities and property.