A Property Bubble


There is nothing worse than being on the outside of a bubble mania. Sydney residential property is on fire and we sold our home 18 months ago. The economy is in the toilet but these low interest rates together with overseas buying are fueling the frenzy.

As a student of economic history I have seen this all before but it doesn’t take away from the annoyance of listening to “this time is different”.

Expertise and Judgement

As I have mentioned in a previous post, Sleeping beauty the difficulties associated with watching a loved one in pain and not being able to help. I have come to realize that whenever someone’s expertise is sought in no matter what field there is very little certainty the more complex the condition.

I am not referring to a case where there are scientific tests where a pathology report can give a confirmed diagnosis. I am talking about those complex mosaics where the diagnosis comes from looking at many different variables. I know this first hand as my step-father is a doctor and I have listened to him describe how one digs deep into their experience and look for an intuitive edge when trying to make a diagnosis of a complex condition. He always says medicine is an “art and part science”.

The other day a certain condition presented to the doctor looking after my daughter that prompted us to consult a good friend of ours who is a pediatric cardiologist. Following a lengthy consultation it appears we may have come up with a rare condition diagnosis that could explain my daughters hell over the last 6 months. However, it isn’t so clear cut as that. The team of doctors on my sleeping beauties case are not all convinced with this new diagnosis.

When I think of the markets and the economy I used to think as a young university student that the answers were clear-cut in black and white. It seemed so obvious if inflation was at x level and interest rates at y that the obvious solution would be z. As I got older I realized that the variables I was considering were only the main ones, however each main variable had their own derivative branch of visible or psychological variables making for an infinitely complex system, that NO ONE EXPERT has the solution for all the outcomes. At this point of my epistemological journey I realized that one has to apply considered judgement to the complex.

Last Sunday I spent a few hours on a very important communal committee which required deliberating on a policy that would have far reaching consequences. The person who made the largest contribution to the deliberations was an active Judge of the Supreme Court. I was really impressed by the process in which he unpacked and then approached the issue.

This got me thinking about how we deal with decisions and express expert opinion without absolute knowledge. Like a judge who wasn’t at the scene of the crime, there is no way of knowing with absolute certainty (excluding cases where there was video footage, like the blood test for a doctor) who did what exactly. Rather the expert is expected to consider all the evidence and apply a test for reasonableness. I think we need to really view ourselves like judges when making a judgement call on the markets.

The US Dollar after the Fed Hikes

I think this is a terrific chart presented by Jawad Mian. I am so tired of everyones postulating whether the USD is going up or down, and whether the Fed is going to hike or not. Who the hell knows when the Fed will hike, but going back to 1970 and the last 17 Fed hike (starts) cycles the USD has actually weakened.

I find this kind of empirical research informative.

Source: Nodea Markets

Source: Nodea Markets



Low interest rate projections

John Hussman strategic growth fund is getting absolutely killed in the current bull market but he remains one of the clearest economic thinkers I follow. His research is top draw here are some interesting insights:

“it’s tempting to believe that low interest rates “justify” elevated equity valuations. But as one can show with any straightforward discounting method, even another 5 years of zero short-term interest rates (compared with a more typical 4% short-term yield) would only justify valuations about 20% above historical norms – essentially 5 years x 4%. Instead, current U.S. equity valuations are about 112% above historical norms on reliable measures. To justify current equity market valuations, interest rates would need to be held at zero for the next quarter century. Understand that while suppressing short-term interest rates may encourage yield-seeking speculation that results in rich stock valuations, those rich valuations are still followed by dismal subsequent returns. Emphatically, low interest rates do not raise the future return on stocks – quite the contrary.”

Here are some further insights Hussman brings from Daniel Kahneman.

So why do policy makers so wildly overestimate the real economic effects of monetary policy (while vastly underestimating its effects in distorting financial markets)? In his book, Thinking, Fast and Slow, psychologist and Nobel laureate Daniel Kahneman describes the biases and rules-of-thumb that people often use to estimate the impact of one piece of information in explaining another. When presented with some piece of evidence, some judgements rely on precise calculations and historical estimates. Others, Kahneman writes, “arise from the operation of heuristics that often substitute an easy question for the harder one that was asked… As a result, intuitive predictions are almost completely insensitive to the actual predictive quality of the evidence.”

Kahneman describes the way that these intuitions give rise to inaccurate predictions. First, some piece of evidence – the stance of monetary policy – is provided. The associative memory quickly constructs a story that links the evidence to whatever is to be predicted – the most likely story being that easy monetary policy will boost the economy, while tight monetary policy will slow it. The next step, says Kahneman, is “intensity matching.” The flimsy evidence is ranked in intensity, and that same intensity is used to produce the forecast for the variable to be predicted. So regardless of whether monetary policy is actually correlated with the economy or not, we naturally assume that extreme monetary policy should have similarly extreme effects on the economy, and in the expected direction. As Kahneman writes, “Intensity matching yields predictions that are as extreme as the evidence on which they are based, leading people to give the same answer to two quite different questions.” In this case, one question is “how easy is monetary policy?”, while the other is “where is the economy headed?”

The problem here is that the quality of the evidence – the strength of the correlation – is not being considered. Kahneman offers a way to improve on these intuitive predictions. In the present context, that method would go something like this: 1) Start with an estimate of economic growth in the absence of any monetary intervention; 2) Estimate the rate of economic growth that best seems to match the intensity of monetary policy; 3) Estimate the actual correlation between monetary policy and economic growth (hint: about 0.15); 4) If the correlation is 0.15, move 15% of the distance from the baseline GDP growth to the GDP growth matching monetary policy.

[Geek’s note: You can show statistically that if Zy and Zx are standard normal variables (where, for example, Zy is just GDP growth minus its mean, divided by the standard deviation of GDP growth), Kahneman’s formula gives the best linear estimate of Y given X, since the beta in a regression of Zy on Zx is just the correlation between the two. To illustrate, the mean of quarterly real GDP growth is 3.2% at an annual rate, with a standard deviation of 3.9%. The historical mean of the federal funds rate is about 4.9%, with a standard deviation of 3.9%. So holding the fed funds rate at zero is a Z statistic of -1.25. With a correlation of -0.15 between fed funds and subsequent GDP growth, at best, this translates to a Z statistic for GDP of 0.19, and multiplying by the standard deviation of GDP suggests that holding fed funds at zero would be expected to provide a bump to real GDP growth no greater than about 0.7% annually. That figure strikes us as about right, though in practice, GDP growth in recent years has fallen short of even the baseline that one would have projected in the absence of monetary intervention].

How much impact should we expect a 0.25% increase in the fed funds rate to have on economic growth? 0.25% is only an increase of 0.06 standard deviations in the fed funds rate, which would reasonably be associated with -0.15 x 0.06 = -0.009 standard deviations in GDP growth. So based on the historical relationship between the fed funds rate and subsequent GDP growth, the impact of a quarter-point hike in the fed funds rate would be expected to be a reduction in GDP growth of just four one-hundredths of one percent below what would otherwise be expected in the absence of that change.

Ignorance is Bliss and Insight is Torture

I have a friend, lets call him Zed, who despite being a lovely person, has always been afflicted by the “Keeping Up with the Jones’s” syndrome. In fact Zed says he is the Jones’s 🙂 .

Zed is academically smart and he and his wife have solid professions, but not the type that you would associate with substantial wealth accumulation. However, that is not something that will stop a hungry, ambitious person with no knowledge of economic history, and a favourable interest rate cycle. In fact the most favourable interest rate cycle of all time.

You see 15 yrs ago Zed converted to the Australian religion of Property Only goes up. This myopic economic understanding has proven exceptionally profitable for Zed, as he now lives in a $5 million home with two luxury cars and two overseas holidays annually.

More recently the absurdity of Zed’s circumstances highlighted that we have seen this movie before. In fact it wasn’t a long time ago across the Pacific Ocean pond that we saw the US housing market collapse under the weight of bad loans. Here is the part that makes this story point come to life.

Zed just ordered a dream luxury sports car to bolster his material image. Ok we could forgive Zed if things on the business front were humming along. No, if only that were the case. Zed’s business is going down the toilet his turnover has been steadily dropping over the last few years and business is currently so bad that he is barely able to draw a reduced salary. But fear not, interest rates are so low and the growth in value of his residential property has provided him with a very nice equity cushion, which he happily draws down on. Gone are his interest rate fixes which might give one certainty for a few years in favour of milking every cent of the lower rates to finance his extravagant lifestyle.

According to Zed I am a dumbo and don’t understand the demographics and the fact that property has only gone up or sideways for the last 40 yrs. The fact that I have a Ph.D. in economics and spent more than 12 yrs as a senior executive in the property industry is lost on his cognitive bias, and financial need to be right.

Meanwhile I have absolutely no desire to lead the extravagant lifestyle my friend Zed “enjoys”, but I watch him increasing his debt against his inflated asset all the while knowing that long term consumption in substitute of investing in productive assets is a one way journey to poor street. I am witnessing Zed climb an ever higher diving board, but he doesn’t realize that not only is he diving into a shallow pond but the water in which he is diving into is leaking.

Knowing that there is only one way this will all end is absolute torture as I watch good people fall into the traps of materialism and to a lesser extent have to endure the ridicule of my circle telling me how I am so wrong. Remember the famous words, “this time is different” – Not!

Hoisted by Your Own Petard

I am sitting in my local coffee shop sitting behind a group of brash high school boys who instead of being in school at 10am are busy sipping coffee and ordering fancy breakfasts. There is however one young ring leader whose arrogance and self belief in my opinion is climbing off the charts, I hope this isn’t my own bias but a fair observation.

I don’t know enough about this kid to comment on whether he is a nice person. However I do know the family and know he comes from enormous wealth. He has been built up by his parents and their considerable influence as a tech genius. He knows nothing of my observation as I watch his feet tapping away with all this energy. He is banging away on his iPhone and his buddies are hanging on his every word. He has just come back from a trip to the US where he “interned” for some of the great companies and gained considerable media attention, all while still at school.

I end with my title line, not sure why that phrase came to mind but its meaning I think is quite apt. In many similar cases one creates a monster that lands up blowing up in ones own face.