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Why markets are cyclical: ‘The Principles of Political Economy’

Why do economic cycles and property cycles occur? WHy can’t the market find a happy equilibrium?

The first thing to understand is that…

Cycles are normal – and healthy
In financial markets the specifics change but the fundamental ideas remain constant. John Stuart Mill’s The Principles of Political Economywas the most widely read economic book of its time and it was written as long ago as 1848.  One of Mill’s key arguments was that investors’ expectations of profit could themselves impact the market, causing prices to rise at first rationally, and then later speculatively, before tending to fall again when the tides turn.We have seen super-charged capital growth in a number of property markets over recent years, notably in Perth (particularly from 2005 to 2008) and more recently in Melbourne (broadly from 2009 to 2011).Mill’s Principles of Political EconomyBear in mind, here, that this book was written in the mid-nineteenth century! Here’s Mill:”The inclination of the…public to increase their demand for commodities by making use of all or much of their credit as a purchasing power depends on their expectation of profit. When there is a general impression that the price of some commodity is likely to rise, from an extra demand, a short crop…or any other cause, there is a disposition…to increase their stocks, in order to profit by the expected rise.

This disposition tends in itself to produce the effect which it looks forward to, a rise of price: and if the rise is considerable and progressive, other speculators are attracted, who, so long as the price has not begun to fall, are willing to believe that it will continue rising.

These, by further purchases, produce a further advance: and thus a rise of price for which there were originally some rational grounds, is often heightened by merely speculative purchases, until it greatly exceeds what the original grounds will justify.

After a time this begins to be perceived; the price ceases to rise, and the holders, thinking it time to realize their gains, are anxious to sell. Then the price begins to decline: the holders rush into the market to avoid a still greater loss, and, few being willing to buy in a falling market, the price falls much more suddenly than it rose.”

Property markets have corrected through 2011 and early 2012

Through 2011 and early 2012 we have seen a level of correction in most property markets, as anxious owners were keen to realise their gains, and new buyers became unwilling to enter the market at the peak of the cycle.

Residential property market corrections often react differently to share market downturns, as a high proportion of dwellings are held by owner-occupiers rather than solely investors (which is in stark contrast to the dynamic of equity markets). As noted in a previous post, George Soros observed that only “once in a blue moon” does a short circuit in leveraged markets trigger a genuine free-fall.

The good news for property owners is that falls to date have been both moderate and monotonous, and further they seem to have stabilised over a period of several months. In many areas moderate growth has even returned.

While excitable journalists and vested interests reported this week that property prices “could fall by as much as 12% to 15% over the next two years” we simply need to be aware that property is a long-term game with an unpredictable near-term outlook.

The long-term view is important

We need to view all market corrections in a wider context. The Dow Jones, by way of an example, has roared back up to near all-time highs at 13,500 points in only a few short years after the global financial crisis.

‘Crashes’ can be also be corrections – it depends on your timeframeLooking at the ‘horror’ stock market crash of 1987 (with all of its sensationalist headlines) in the rear-view mirror, the crash looks like little more than a blip in the upwards-trending chart.In the year to September 1987 the All Ordinaries index increased in value by a spectacular 100% up to a peak of 2,106. Then, from late September 1987 the index fell by precisely 50% from 2,106 to 1,151 in less than two months.There are two things to note here. Firstly, that if we remove 12 months from the chart, the crash is nowhere to be seen: the market is simply where it was before the irrational exuberance began. Secondly, even after the global financial crisis brought the market tumbling down again, the All Ordinaries index (XAO) today sits at above 4,400 – a world away from the values seen in 1987.Understand the arithmetic

In the 1987 example above we have doubled one to get two, and then we have halved two to make one. It is very simple mathematics, so it should be a correspondingly simple paradigm shift to change your mind-set from a short-term to a long-term horizon. Instead of worrying about the next six months or year, try to visualise where the market will be 20 or 30 years from now.

The property markets need a shot of confidence

While it seems logical that property prices should rise no faster than household incomes, what instead tends to happen is that prices stagnate or drift lower for a period of time, before appreciating sharply. Markets are not rational, and they never have been because they are affected by human emotions…and humans are not rational beings.

What property markets will need for strong capital growth to return is an injection of confidence. This may take some time to come, but we know that markets are cyclical and come it will. Interest rates look likely to fall yet further at this juncture, and in turn the currency is likely to weaken somewhat too.

These twin forces will gradually lure investors back into the market, first from Australia and then from overseas, and growth will eventually return again. Of course, to out-perform we should always seek markets, suburbs and property types that look set to boom on a counter-cyclical basis.

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About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


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