The Valor Blog.
Investment News and Views, Direct from Our Team.

Down the rabbit hole…

When the average person cant afford the average house, you know you have gone down the rabbit hole. When knock down houses are 5 times what the average person can afford, there is no Lewis Carroll book kooky enough to describe the situation.

Australia has a problem of epic proportions. We have one of the biggest property bubbles of all time. We are up there with Ireland in 2007 and even Japan in 1989. We are in the company of property bubbles that eventually deflated more than 50%. The government has fuelled the bubble with terrible incentives such as tax deductions to speculate on capital gains and lately decided that using retirement savings to add more oxygen to the flame would possibly be a good idea.

Rationality always returns. No one knows when or how, but it always returns.

We have a strong opinion that the economic conditions that are coming to Australia are likely to be far less supportive of current asset prices, but the timing of this downturn is uncertain. We think it is coming sooner rather than later. When Australia’s return to rationality arrives, we may not see asset prices at these levels for decades.

For the historically unaware, there have been numerous bubbles which have had zero returns for decades. In other words, you lost money and only got back to a zero return decades after the peak. The 1920’s bubbles which peaked in 1929 took until 1954 to return to previous highs. Japan’s property market is down over 26 years. Most recently, the 2000 stock bubble took 13 years to get back to zero.

The metrics we currently preside over for Australian property are far closer to the metrics of some of the worlds greatest bubbles than many would care to admit. We may see decades of no returns. For those that manage peoples retirement savings, they must take this warning very seriously.

This may come as a shock to those that think property only ever goes up. In a declining interest rate environment, it is not difficult for property to go up as people borrow more, but one day, interest rates will begin to rise and with that rise will be the end of what we currently know as one of the greatest bubbles of all time.

Before the interest rate rises, we fear that the unemployment shock of the end of the mining boom has the potential to end the current party.

At Valor, we spend considerable time reading and studying ways to avoid losing money for our clients. Sometimes it is relatively easy to avoid losing money, sometimes it is not. We are quite confident that investing in residential property and Aussie banks which are mainly residential mortgage leverage machines is likely to be a fantastic way to lose money over the coming decade. It might start this year or it might be another year or two, but when Australia eventually has another recession, all bets are off.

Many might think that if you shouldn’t invest in banks, houses or miners, then what is there left to invest in in Australia? Well that is a very good question and one we can’t answer because Australia is pretty much just banks, houses and miners. When the latter of that group returns to much lower profits at best, Australia is left with very little to support our economy.

At Valor, we know that the great majority are not invested in the way our clients are. Our clients are invested in the worlds best businesses and significant cash holdings. The businesses we invest in are highly likely to be selling more of that they do for decades to come and we will continue to make our clients very health returns. The great majority of the businesses we own have no debt and some even have up to 20% spare cash. The great majority of Australian investors have nearly half their Australian shares in exceptionally geared banks or hold huge exposures to negatively geared property.

Our national sport is not Aussie Rules. It is borrowing money to invest in housing that doesn’t come close to covering the interest payments (even at historic lows in interest rates). This is likely to be a blood sport in the coming years.

I look forward to the day when Australia returns to being a productive nation which has numerous global brands, a rational and conservative banking system and a more diverse group of industries. Until that day, I will continue to invest the majority of my clients money outside Australia where the opportunities to compound my clients money are not reliant of selling second hand houses at constantly higher prices to each other with increasing amounts of debt attached.

For those that read our newsletters and blogs over the years, you will note that we warned about the end of the mining boom very close to the top in early 2011. In fact I signed a napkin with some of my colleagues from my previous adviser group declaring that we had reached the top of the mining boom and that BHP and RIO would halve over the coming years. All the other advisers had a bit of a chuckle at my expense. We are nearly at the 50% losses mark and yet I think I may have been too conservative.

I fear that if I was to sign a napkin today on how far the banks could fall in a significant property correction, a 50% fall in bank share prices would not be anywhere near the bottom. I do remind you that Buffett lost 99% on his investment in Irish banks. Citigroup and Bank of America lost around 95% of their value. Not to mention the numerous banks which went to zero over the last decade including Babcock and Brown, Allco, Lehman and other nationalised banks. Banks are extremely risky investments.

There is no floor on the share prices of the Australian banks.

I cannot stress more strongly that I do not profess to know exactly where the valuations of the banks will end up and no one does, but what I am attempting to warn about is the probabilities for loss and the size of those losses is far greater than many can comprehend.

The secret to creating wealth is to avoid losing money.