Back in the days when I wrote company Annual Reports, one of the many headaches for us accountants came in how to value share options issued to directors and key management personnel in the Remuneration Report.
The miracle equation?
But when the equation became known in it was anything but dull – it was the miracle equation which could produce the Holy Grail: risk-free investment!
It seemed possible to perfectly hedge an option by buying and selling the underlying asset in order to eliminate risk, which is every investor’s and every hedge fund’s dream outcome.
The equation implied that there is only one true price of an option and also made a number of key assumptions, one of which was that there would always be available buyers and sellers of a stock, particularly when short-selling.
It was adopted by investors everywhere and contributed further to the boom and bust cycles.
Markets are not rational
But therein lay a problem.
The Black-Scholes equation could only eliminate risk if it were true that investment markets are always rational.
However, investment markets are driven by human emotions including fear and greed and therefore are anything but rational.
The 1987 Black Monday crash demonstrated perfectly the irrationality of markets with the Dow falling by 22.6% in one day.
We saw the pattern repeated in the financial crisis when markets plunged…and then kept on falling with scant regard for anything approaching rational behaviour.
Crucially when markets crash in this manner there is not always an available buyer for your asset regardless of whether you are hedged or not.
This demonstrates one of the great truisms of investment: there is always some prevailing risk.
Housing market credit crunches can sometimes work in a similar manner.
It had been thought that over time markets would learn from the mistakes of the past and become more rational, and booms and busts would become a thing of the past. But this has been shown to be incorrect, with cycles as much in evidence as ever.
When a credit cycle reverses, sometimes the supply of available credit dries up when, for example, lending institutions collapse or become unwilling to lend while fearful of toxic assets. This was seen recently in the US with dramatic consequences.
The lack of credit sees dwelling values fall very sharply and businesses becoming unable to operate effectively. A credit crunch is always and everywhere felt very painfully by the economy.
The Minsky Moment
The ideas of Hyman Minsky, which previously didn’t receive a great deal of attention are now all the rage, particularly with academics and theorists. Minsky noted that investment markets move through five stages in a cycle:
When credit cycles reverse, Minsky argued, there comes a point or key moment where asset values fall below the value which they were bought for, panic selling ensues and then the decline in asset values accelerates as panic eventuates.
As recently as the middle of 2012, the usual doomsayers were adamant that house price falls would accelerate, and yet it did not happen in the second half of the year.
And so to 2013
Of course, the short-term future is always inherently uncertain and further falls could yet be witnessed.
Almost without exception the forecasting houses have predicted moderate property price gains in 2013 due to the Reserve Bank (RBA) having dropped interest rates from 4.75% to just 3.00%.
On the other hand, for at least the fifth consecutive year now Professor Keen is predicting property market corrections, although he has seemingly toned down his infamous “40% crash” claims to more of a “slow melt” theory.
Who is right?
The correction in the property markets through 2011 and the first half of 2012 was healthy for Australia overall. It is not desirable for property markets to continue to boom for year after year leaving all other asset valuations in their wake.
Ultimately, when credit cycles reverse there are only really two things which can happen.
One is that panic ensues and prices crash, and the other is that prices ease moderately for a prolonged period of time before stabilising.
Although there are thousands out there praying for a crash, we should always be careful what we wish for (the same goes for property bulls who are hoping for yet lower interest rates).
A property market crash destroys consumer confidence and is likely to result in a full blow recession, high rates of unemployment and other fallout.
It seems that, to date at least, we avoided the crash, but why?
There are two main reasons.
One is that the major bodies such as the RBA, the Government and the banks will do anything in their power to engineer a softer landing for prices.
The second point is related to the growth in population.
A word of warning: whenever someone says “it is different here!” that should be an automatic red flag, but I’ve never understood why Keen and the gang insist on comparing Australia with Japan.
Sure, Japan’s property prices fell and fell into a negative spiral. But look at the difference in what is happening to the respective populations of the two countries.
Australia is populating at an incredible speed and will continue to do so for decades to come.
That is a very stark contrast with Japan, whatever the Minsky model might say.
“But I bought a house for $X…”
As sure as night follows day someone will enter this argument with a comment such as “in 1990 I could buy a Sydney house for $300,000”.
I’ve written many times about why we won’t see those prices again, including the growth in population and demand, the growth in two-income households and, most pertinently, the fact that home loan interest rates today are no longer at 17% and have not been so for more than two full decades.
There has been a structural shift towards lower rates which inevitably sees households gearing up.
Can property investors still thrive in times of moderate growth?
The final key point is that property investors do not buy “the housing market”. If they did, then property wouldn’t be much of an investment.
Instead, smart investors look to invest counter-cyclically in properties close to the median price, in land-locked suburbs in major cities experiencing massive population growth.
The headlines may trumpet that “property prices only matched inflation” or “property prices slipped in real terms” but thousands of investors secured their financial futures in only the last half decade simply by investing in properties in massive and growing demand.
Will the next decade be any different?