Should the bank shares be rising as house prices fall?

I have seen numerous portfolios of clients who come to me with 40% and even 50% invested in Australian bank shares.

With house prices across the entire globe falling and bank shares (apart from the Aussie ones) having fallen 80% or 90% and numerous failures, why do Australians persist with the notion that investing almost half your capital in these grotesquely geared entities is considered a safe practice?

The above average intelligence guys at the Intelligent Investor wrote in the back of one of their recent newsletters that they believe a maximum allocation of 10% of a portfolio should be invested in the Australian banks. I completely agree. Although at Valor Private Wealth, we believe that the Australian banks have limited upside and potentially large downside and this is not the kind of investment we feel comfortable owning for our clients, so our current weighting to Australian banks is 0%.

The capital requirements of the banks are about to come under closer scrutiny over the coming months with Basel III. There is talk of some of the enormous off balance sheet derivatives being required to be brought onto the balance sheet. I have spent countless hours attempting to work through this issue, however as the reporting for these instruments is still quite opaque, any work done has limited application. When the derivatives listed in the banks are in the trillions for each bank, small movements  can have enormous affects. The vast majority of these instruments are simply hedges, however as seen with the JP Morgan losses of late, trading losses can be large.

One of the biggest concerns is the accounting of capital for the banks. With house prices rising over the last decade around Australia, there has not been any issues, however since October 2010, house prices have begun a gradual retreat and if this continues, the banks could prove to be swimming naked when the tide goes out. Westpac and Commonwealth have the highest proportion of residential mortgages at about 2/3 of their book, whilst ANZ and NAB are holding approximately 55% and 50% respectively. The ugly girl at the dance (NAB), who has been a stellar under performer may actually be the least worse bank!

So the latest reports of house prices continuing to fall why are the bank shares rising? Deep T from Macro Investor has highlighted the risks to the banks with continued house price falls. In reality, the banks are a levered bet on house prices in Australia. If the market was rational, then the bank shares should move at a greater rate than the house price falls or rises. This was definitely the case when house prices were going up, but there appears to be a disconnect with house prices falling 5% year on year nationally and bank shares rising approximately 15%.

In a situation of continued house price declines, it is the LMI (lenders mortgage insurance) insurers that are most at risk. QBE and Genworth could shoulder enormous losses, many times their current capital, if house prices fall in a similar fashion to what has happened around the globe. This is something I would suggest is not a negligible probability. Once again, there is very little data about the current LVR profile of these highly geared insurers. In the last QBE annual report, the word LMI only popped up twice. For what I see as one of their largest risks, mentioning the word twice is not what I call keeping investors up to date.

Could a higher dollar lead to a lower dollar?

With the recent further rise in the Australian dollar against a continued slowdown in China and growing fears about a resource investment cliff, I am beginning to see the prospects of a higher Australian dollar leading to an increasingly uncompetitive position in Australia. This inability to compete due to higher wages, lower returns for exporters, cost to inbound travelers may slow the Australian economy leading to lower interest rates and then a lower Australian dollar.

The question is how high does the Australian dollar need to go before it bites itself in its own bottom?

With the general consensus that our LNG boom may not be the saviour it is expected to be due to the shale gas boom the the US, people are beginning to understand how our persistently high Australian dollar is sending future growth prospects away from Australia.

Our general view at Valor Private Wealth is that interest rates will continue to fall over the coming year and possible the year after that and along with it the dollar will lose its shine as the interest rate differential reduces. There is likely to be a tipping point where the current flow of money into Australian dollars reverses. Where that tipping point sits is unknown, however when it turns, it is likely to be a sharp reversal similar to 2008.

The Fiscal Cliff and Investing

The Fiscal Cliff is a potential problem for the US. The issue is real. Whether or not it should be up for debate is another question.

The US does need to fix its government finances, but they are not unfixable problems.

But how does the Fiscal Cliff affect long term investments?

If the US goes past its deadline, will Coke sell less cans of Coke over the next 10 years because of a deadline to agree on some tax and budget cut issues? Probably not.

Will less people "Google"something and click on the adds next to the search engine? Probably not.

Will the excess houses in the US that are being mopped up over the next few years all of a sudden not continue to reduce the supply? Probably not.

Will the shale gas revolution grind to a halt and stop the US drive toward energy independence at some stage over the next 5 to 10 years? Probably not.

Will sentiment increase the share market volatility? Likely so.

So if the Fiscal Cliff is unlikely to make a dent in the worlds best businesses, then does it provide a good opportunity to add to these businesses at reasonable prices? Likely so.

Both Jim Chanos and Warren Buffett have recently stated that the Fiscal Cliff is not changing how they approach their long term investment philosophies and I recommend that you do the same.

China Recovery Unsustainable

Another great article from Macroinvestor outlining the recent appearance of a recovery in China.

The HSBC PMI data came out in expansionary for the first time in 13 months.

I must agree with the FT Alphaville's comments on Nomura's analysis that it is unlikely that the recovery in China is sustainable. If your problem is building empty offices, apartments, shopping centers and other infrastructure, then it is not sustainable to build more empty offices, apartments, shopping centers to fix the problem.

At some stage, China is going to have to take the bitter pill. The current leadership change appears to have delayed that difficult transition from fixed asset growth to more balanced growth, but the more they delay it, the more difficult it becomes...

Does Xi and his team have what it takes to turn the behemoth around? Do they have the ability to stop corruption from eating the country from the inside out? Or as Hu Jintao described it "kill the party and ruin the country"...

Deflation to continue?

A good article here by Stephen Koukoulas regarding the low inflation environment we are currently in.

The most important point is in the last paragraph. It states that "inflation will be staying too low despite the best efforts of the G7 central banks to kick it higher".

When central bankers have their backs against the wall with a choice of inflation or deflation, it is a good bet that they will strive for inflation every time. Whilst no one knows if or when inflation might kick it, it is not wise to invest your hard earned savings on the assumption that it is not around the corner.

Those holding too much cash or low yielding bonds when inflation rears its ugly head should get their rubber duckies out because they could take a bath.

Housing Recovery?

A very well weighted argument for both cases of the housing recovery from Matthew Kidman here.

I am not going to comment on which way I think the housing market is headed, because I dont know and no one really does. (I am slightly more bearish than Matthew Kidman though). What I do know is that there are an enormous number of people betting the majority of their retirement savings on a sustained recovery in Australian real estate. People with highly geared investment properties who are in their 50's, retiree's with 30%, 40% and even 50% of their superannuation in Australian bank shares and the countless number of baby boomers who are planning to downsize and use the current equity in their houses to supplement their super.

Whilst all of these strategies may pan out, they are not as guaranteed bets as those who are relying on them believe they are. If the loss of confidence in high indebted nations that the rest of the western world are experiencing invade our shores, then these residential property dependent strategies could make a serious dent in many peoples retirement dreams.

Our view is that to place such a large bet on the sustained recovery in the Australian residential market is to bet that unemployment will remain at extremely low levels for many years to come. We believe that betting that unemployment will remain at five and a half percent for the foreseeable future is not rational. The history of the last hundred years suggest that a cycle in Australia should average every 8 years or so. Just because we haven't had a cycle since the early 1990's does not mean we should base our investment strategies on one not occurring. 

The raw numbers are not in the favour of those with heavily weighted bets on the recovery. Enormous mortgage debt to GDP up there with the worst in the world, a mining investment boom coming off its peak in the next few years and the baby boomers retiring does not suggest we are expecting a boom any time soon. Having said that, if interest rates continue to fall, there may be some "hot" money flowing into the markets.

My travels around the world as an international pilot allows me to compare average housing costs in different cities and countries. Australia really does have some crazy prices when compared to other fantastic cities with larger populations. This disparity in prices may be purely due to the hot Australian dollar, but I am not sure that this is the only factor creating the difference in value for money.

With some fantastic assets on sale in the rest of the world, now is the time to diversify your risk from the scenario that Australian residential housing does not have a sustained recovery that many people are so dependent on.

Ice Cream for Breakfast

Warren Buffett eats ice cream for breakfast and doesn't have an email account...

Interesting new series from CNBC.

Betting on something worth betting on...

Yesterdays "Race that Stops a Nation" was exciting.

Unfortunately I find it difficult to throw away money on this kind of venture. I have previously put down a few bucks just to have a bit of fun, but with a race so open that almost anyone could win, it is not the kind of odds I prefer to play with.

The key point I wanted to make in todays blog is that betting on the horses is not much different from the way many professional punters/ investors invest their clients hard earned money.

The majority of professional investors have a very myopic view on managing money. They generally dont think past the next 12 months when investing. This can be seen by the turnover of managed funds portfolios often around the 100% per annum range.

This hyper activity is crazy.

Betting on what a stock is going to do in the next 12 months does not give very good odds. Even the best betters can't get much more than 50/50 odds. If you ask a bunch of fund managers whether BHP will be higher in 12 months time, the answers would vary wildly because no one really knows!!

Compare this with the probability of Coke (KO) selling more Coca-Cola's and putting the price up over the next 5, 10 and 15 years. The probability of this is unbelievably high.

The secret to investing is to wait until the very high probability companies are trading in a range that is worth betting on and then hold them for a very long time. This doesnt happen often.

As Buffett eloquently said:

     The market is designed to transfer money from the active to the patient

When investing, you are looking for horses that win year after year. For decades at a time. Put a punt on when they have a bad race one year because it is more than likely just one bad race.

Walmart was a good example of this. Recently Walmart had the Mexican corruption scandal. Was this terrible offense going to affect the earnings of Walmart significantly over a 5, 10 and 15 year period? Probably not. This gave investors an opportunity to place their bets on a winning horse with fantastic odds that had one bad race.

Many people see the market volatility and get worried about the risks of the ups and downs. When you look through the noise and just see the wonderful companies working hard to grow their earnings over time, you realise that most of the noise in the market is the "punters" (often professional investors) who are betting on very average short term odds.

For those that ventured to their local pub yesterday to watch the race, you may have noticed that the scene looked not dissimilar to the stock market floors of decades ago. People throwing down bets and shouting at screens. The reason for this is because the majority of the market is just punting on short term odds which as a general rule is not an overly productive pastime.

Accounts Receivable...

If the figures are correct in this article from the Diplomat, then those hoping for a turn around in China in the fourth quarter may be in for a shock. Then again, I wouldn't hang my hat on any accounts out of the "Roach Motel" giving accurate figures.

Bond Bubble???

The global search for yield has driven the safer end of the bond market the historic lows, but the middle to lower end of the bond market is having money thrown at it too.

These do not appear to be rational allocations of capital in a world where Helicopter Ben and Super Mario have outlined their preference for inflation rather than deflation during their reign.

Lardy vs Pettis

Here is a fantastic letter from both camps on Chinese growth.

Most know which side Valor Private Wealth is on, but it is important to note that we spend considerable amounts of time looking at the other side of the argument.

Many of our new readers may think that Valor has a large exposure attempting to profit from a slowing China. We believe that China has some difficult rebalancing years ahead, but we prefer to invest in wonderful businesses that can grow their owner earnings over the next few decades. Our main goal is to attempt to remove as much risk from our clients portfolios from a China slowdown and the only upside we expect is a potential fall in the Australian Dollar or our international holdings.

Our position is that owning cyclical businesses that are closer to the top of their cycle than the bottom is not a sure path to wealth and can destroy capital faster than most predict when margin contraction occurs.