Despite all of the phenomenal success and wealth he has achieved as a fund manager, George Soros would prefer to be remembered as a philanthropist, and, particularly, a philosopher.
His theory of reflexivity recognises the fallibility of human understanding and how this impacts financial markets.
Classical economics talks much of supply/demand curves and markets returning to equilibrium (or reversion to the mean).
What Soros recognises is that expectations of future price movements can themselves impact asset valuations: rising prices can attract more buyers, and falling prices can attract more sellers.
Sometimes prices can move into far-from-equilibrium territory and a bubble ensues.
This is easily demonstrated in more liquid financial markets (such as stock markets) where overlaying a graph of Earnings per Share (EPS) versus stock price movements repeatedly shows that the stock prices over- and under-shoot EPS ‘fair value’ cyclically.[sam id=40 codes=’true’]
Real estate markets, having different characteristics such as the use of leverage or debt, sometimes act in a boom-bust manner, where the willingness of credit markets to lend influences the value of the collateral itself.
Credit availability can become a short circuit. Here’s Soros:
“Only once in a blue moon does a prevailing bias set in motion an initially self-reinforcing but eventually self-defeating process. It happens only when the prevailing bias finds some kind of short circuit that allows it to affect the fundamentals.
“This is usually associated with some form of leveraged debt or equity. Both market prices and economics conditions may then move far beyond anything that would be possible in the absence of a short circuit, and the correction, when it comes, may have catastrophic consequences.”
Real estate bubbles
Back in 2008, Soros recognised that several property markets had developed credit expansion that might indicate the presence of a bubble: notably the USA, UK, Japan, Spain and Australia.
The USA found its own short circuit in the collapse of Lehman Brothers and the bursting of the sub-prime bubble. Credit markets froze and the financial system went into meltdown.
Lending standards had fallen to unprecedented lows in the US and the fallout was monumental, as demonstrated in the graph below.
In Australia, however, the financial crisis saw interest rates fall and real estate prices continue to rise. There was no short circuit (and lending standards were notably higher).
This is particularly germane to Australia’s property markets of today which are now in the correction phase of the cycle – the credit markets are still relatively liquid.
Fixed mortgage rates are available well below 6%, and, crucially, banks are still often lending at 95% loan-to-value rations (LVR), which explains why, to date at least, the correction has only been moderate as noted in my post here.
Soros also notes the possibility of a Super-Bubble.
Lending criteria were relaxed in the 1990s and real estate prices took a very significant upwards turn.
Might house price to income ratios at their current level be an anomaly or is expensive real estate the ‘new normal’?
Could house prices return to 3 times incomes? Perhaps, but the truthful answer to this is that nobody knows.
Soros notes that the ability of credit markets to reinvent themselves and create new lending products has been entirely unpredictable in the past, and will continue to be unpredictable in the future.
This inherent uncertainty is precisely why I feel so strongly about only investing in the right types of properties in supply-constrained inner/middle ring suburbs in capital cities experiencing significant population growth. This is also why I am extremely wary of remote locations, speculative ventures, areas of low/variable demand or niche investments.
Observe what has happened in other countries.
For example, compare the difference between the Tampa real estate market (bust) and that of, say, New York (more stable). In England, many regional markets have fallen in value by more than a quarter leaving owners with negative equity.
Meanwhile in many of London’s inner- and middle-ring suburbs domestic and international funds continue to flow, and prices are higher than they have ever been.