October 26, 2008
The current market instability could create lucrative chances for those willing to take a risk.
Because of the panic that has gripped the markets, the next few months will probably be the most profitable opportunity to make money in this generation. But you’d hardly think so by listening to the mainstream commentary in Ireland.
Sometimes it’s difficult not to laugh at the type of advice that is being thrown around Dublin by so-called financial experts. For example, the same lads who were telling you last year that Irish property was ‘‘fundamentally’’ sound and would experience, at worst, a ‘‘soft landing’’ are now telling you that the world is ending.
Last year, these heads were telling you that AIB shares were a buy at â‚¬20.Today they are suggesting that AIB at â‚¬3.7 is a sell. God knows who pays these lads, or why. Nobody is suggesting that the background noise has not changed dramatically. Nor is anyone underestimating the risk involved in trying to stop the bottom of any market, but if we stand back a wee bit, we might gain that most valuable of insights – perspective.
The key thing to appreciate, is that all financial crises are temporary. They tend to blow over. People with debts and companies going into the crisis get hammered and those with cash prosper. The rout in asset prices becomes self-correcting.
Either markets exhaust themselves in a selling frenzy or they get pushed back by the heavy artillery of government intervention. Either way, the system rights itself at a different price and we start again.
We are now seeing huge falls, mainly because hedge funds are selling everything to meet their financial obligations. Their clients are demanding cash and, as a result, the funds have to sell everything they have.
At times like this, the selling becomes indiscriminate, which is why certain blue-chip companies – ones that will almost certainly survive the recession – are offering double-digit yields. Given that global interest rates are headed downwards rapidly, such companies must be a screaming buy.
But like everything in investing, you have to be diligent and, most of all, patient in your research. A crucial dynamic in all these episodes is that markets overshoot. In good times, as we’ve seen to our regret in the Irish property market, markets overshoot on the upside, bringing prices up to ludicrous levels.
In bad times, like now, the same process occurs and asset prices overshoot on the downside, bringing prices down to levels where the assets are at bargain basement prices. We are seeing this now in stock markets.
Unfortunately, this is not happening in the Irish housing market which, on any rational basis, is still wildly overvalued. Last year, this column ran a simple financial model for where fair value might be in the Irish housing market. This is back-of-the-envelope stuff, but bear with me. The price of any asset must be related to the amount of money the asset generates each year.
In the US, analysts claim that, in the long run, house prices should be equal to between 12 and 14 times earnings. This means that if a house is generating a rent of $10,000 a year, it must be worth between $120,000 and $140,000 a year.
Apply this test to Ireland. A quick search of Daft.ie will reveal, for example, that a three-bedroom house in Co Wicklow – advertised as an investment property – is on sale for â‚¬289,000.
The same website tells us that the average rent for a three-bed in Arklow is â‚¬850. So let us say that, in the best possible case, this place is rented for 11 profitable months a year – the final month’s rent goes on various costs. The implication from the American model is that the house is worth about â‚¬122,000.
The implication from this, compared to the advertised price of â‚¬289,000, is that the house is still wildly overvalued. The Irish calculation means that the house is trading at 31 times its annual yield. This clearly needs to fall dramatically by close to 60 per cent for it to make any financial sense to buy.
So one of the factors impinging on Ireland’s recovery is that we have to see house prices fall dramatically for any investor in their right mind to get back into the market. As long as estate agents, banks and builders are in denial about where prices need to go, we will not have a platform for any recovery.
So property investment is out, but let’s go back to the stock markets. The question is whether we are near the bottom? In Ireland, the bottom might take a few more months to materialise because we are caught in a bad debt brace.
Going into the crisis we were the most indebted population in the world. More worrying, practically all of that personal debt had been taken on since 2000, so not only were we indebted but we were newly indebted. Finally, practically all of that debt was property-related.
At this stage – for heavily indebted players – it hardly matters now what happens to interest rates. Sure, a few decreases will help, but the employment situation is of much more consequence for mortgage holders. Unfortunately, unemployment in this country is likely to rise substantially in the coming months and years because so much of our recent job increases were generated by the domestic service sector and the construction sector.
Rising unemployment will prompt industrial-scale mortgage defaults in Ireland and the defaulting process will follow the same pattern we have seen in the US. We are likely to experience what could be described as ‘‘shunting defaults’’, as people’s defaults shunt on from one loan to another. This means that we will also witness large-scale credit card default, many thousands of car loans will never be paid and home loans will similarly be reneged on.
This will lead to house prices tumbling in a delayed reaction. However, this is probably the point at which the Irish stock market will begin to rally.
For the brave, for those who understand the dynamic of markets, this week’s panic should be the signal to begin the process of thinking about investing again. The lessons from history are that turbulent times pass and also present the buying opportunity of a generation.