Naive Investor Chapter 6 Interlude: Bubble Trouble

[This is largely a reproduction of my first draft of Chapter 5 - which is now chapter 6, it is a more thorough explanation and damnation of the 'Turkey Problem' I'm taking the original draft chapter down.]

Property and the Turkey's That Buy it

I'm pretty much lifting this straight from 'the Black Swan' but I feel more often than any other example of investor folly, the problem of Inductive Knowledge crops up in property. (though it is not unique to property).

The naive investor wants unlimited upside and no downside. They are cripplingly risk averse. They are most often blind to the positives of a downward moving price. For example if house prices move downwards they are horrified, they do not see this as housing becoming more 'affordable'.

I say they are turkey's because of Bertrand Russell's illustration of the Problem of Inductive Knowledge, covered thoroughly and entertainingly in the Chapter of 'The Black Swan' called '1001 days or how not to be a sucker'.

Suppose you are a turkey, and every day a man comes and feeds you grain. Your observation is that each time the man feeds you, you have a piece of data, or evidence that the man is looking out for your 'best interests'. For 1000 days the process repeats itself, and all your observations confirm the theory that the farmer is on your side. The 1001st day though is Thanks Giving and the farmer comes and rings your neck.
Crucially, the empirical observations aren't just wrong, but have an adverse effect on the turkey, which is to say the Turkey feels safer as it's danger actually increases. It feels safest, thanks to all the evidence it has collected at the point of its maximum danger.

So too with property 'investors' that at least in Australia will be called 'speculators' once their tremendous losses are realised. And while the farmer may know precicely when Thanks-Giving is, Turkey's aren't privy to the calander, just as property speculators aren't aware of their day of reconning. It will be incredibly hard to predict, especially because they will be feeling more and more secure in their investment right up to the day the market corrects.

It all has to do with the crippling risk aversion. Anything that goes down is a 'loser' and anything that goes up is a 'winner'. The crucial risk a naive investor cannot take is that something would change its most recent behaviour.

Thus they will only buy into something once it has already demonstrated its ability to gain. This risk aversion drives property speculators into markets when they have hit 'historical highs', because the evidence that they will continue to grow is at its maximum. In the Australian property market there is now 16 years of data to suggest that property 'goes up'.

This is the turkey empiricism - 'property has gone up, therefore it will go up'. And of course not just limited to property, but any investment will rise in price right up to the moment it falls. It's just that the property market unlike a particular given company tend to crash as a market, in lockstep. A whole army of speculators marching off a cliff.

Bubble Trouble

One of the more perplexing things about property is that, the unethical monopoly nature of it is fundamentally sound. If you are willing to shelve your morals, then you can monopolise a scarce resource and pocket unearned money taken as 'tribute' from the people who actually do earn it. A localised government of 1.
Sounds harsh but its true, and if its legal you as a citizen are entitled to do it. But you can still overpay for something like that.
Suppose you could purchase the title of 'king of the world'. It entitled you to do whatever you wanted to anyone. If the price was set at $1 trillion dollars I would say ethics aside, take it. But if the price was set at 'all the oxygen in the world' there would be no point, the cost outweighs the benefit.
Similarly people buy into the property market, as sound as the monopoly is at a price where they recieve no benefit from it.

Michael Hudson's answer to the question 'How much is a house (property) worth?' is 'As much as a bank is willing to lend for it.' Sad but true, something that makes Peter Schiff say 'People don't own houses they rent them from the banks.'

Banks control money supply, and in a reciprocal fashion - banks can lend as much money as people are willing to borrow. A bank really facilitates bubbles, because individuals funds are generally limited, especially when compared to their desires.

This in turn is largely because of private property which ensures pretty much all resources are already monopolised by somebody else the moment you were born, you have to buy said resources of them and they won't sell unless its at a premium.

The turkeys that are satisfied though that 'house prices have gone up therefore they will go up!' aka speculators, are willing to borrow more money. The banks will lend them the money and are somewhat turkeys themselves, feeling safe to lend to a lowered standard of speculator because history confirms that they can always repossess the house and sell it at a profit to recover the debt. The one caveat is that Banks actually make money from housing (at current prices) where most property speculators do not.

The turkey problem, creates bubbles because the price will rise (as an investment) to the point where you make $1.01 in rent for every $1 invested on an ongoing basis. But speculation simply pushes it beyond this threshold, because the price has risen thus far to that point. Get enough speculators in the market and you inflate the price beyond it's investment capacity. This inflation of the price creates an asset bubble.

The turkey's look like geniuses right up until the bubble bursts where they are condemmned as speculators, but this doesn't cure their risk profile, the turkeys simply shift their eyes to another promising empirical experiment. Hence you see a property cycle that goes Bust-Boom-Bust-Boom-Bust-Boom. In all those Bust times you get things like Franchise Bubbles, Tech Bubbles, Oil Bubbles etc.

The Bank Is Laughing At You

I'll now explain the folly of investing for capital gains. Can you predict the behaviour of turkeys? Or rather, can you predict the weight at which a turkey is fat enough for dinner? Especially just by looking at it. Sure there will be extreme 'easy calls' either way. A turkey that ways 50g is obviously just a chick, just like a house that costs $1 on ebay is not likely to go much lower. A turkey that weighs 50kg should already be dead.

The property market is just the same. If house prices where $1 trillion this year it would be easy to say 'this isn't sustainable' it would probably mean the collapse of the currency yet alone the housing market. But right now it's hard to say whether a house priced at $650,000 in Footscray is getting close to the kill or whether $700,000 is too high.

That call is much harder to make. Especially because if your P/E multiplier is at 60 already, its irrational. There's no rational reason to buy, so why would somebody buy at 61, 62, 70, 80, 800? This was true of the tech stocks as well. Many people were buying companies that made no money at price multipliers of 600 and greater because the price had increased so far.

Once an investment leaves the boundaries of reason, it is speculative, and prediction is impossible from then on. The only thing that is almost certain (but never quite so) is that gravity will take hold at some point.

But why oh why, do banks facilitate this? Also if property is such a great sound investment, why don't the banks just buy property for themselves and then rent it to us?

They do, but they do it by loaning money so people can buy them themselves. It has numerous advantages for a bank.

If a bank bought a property that got $300 of rent a week, they would make $300 of rent a week back on their initial investment. If they convinced some turkey to borrow money to buy that same property with $500 mortgage repayments per week though, they are making an extra 60% of income on that investment. The tennant 'helps' pay off the mortgage with their rent, which comes out of their pocket from their productive earnings, then the turkey flips $200 extra dollars out of his pocket to the bank.

What is in it for the turkey? The hope that some other turkey will buy into (and him out of) this ridiculous arrangement at an even higher price. That is they will contribute $201 or more to the banks rental income rather than $200.

The bank earns all AND MORE of the productive income from 'investment property' that is their carrot to facilitate speculative behaviour. The 'paper wealth' goes to the turkey because it just facilitates more income for the bank.

Property is an Investment when...

Again casting ethics aside, if you the naive investor want to buy property as an investment (and I won't help you do it) when it meets the following criteria:

1) Rental income is cash flow positive.
2) The return on rent is greater than the next best investment opportunity. (something surprisingly easy to fail with property).
3) The Price/Rent (i'm making it easy for you) is in a reasonable neighbourhood of 20-30.

With ALL those criteria filled you may also want to consider Fixing your interest rate. This leans towards the 'margin of safety' so central to Benjamin Graham. If you can fix your interest rate and still satisfy the above 3 criteria, then you are dealing with a known quantity and are making a return on it.

Thus it fits the universal criteria of investment - it increases your purchasing power over time, it also would virtually guaruntee safety of principal as if you buy it at a reasonable price there is a fair chance you can offload it to some turkey at an unreasonable price.