This is the second part of ‘Evaluating Values’ and as with film sequels and second albums which tend to disappoint, please therefore lower your expectations of how useful and interesting this will be.

In the first instalment, prior to ascertaining how shares can be valued to identify the ‘fair’ price, we started off by asserting that the average investor is highly sensitive to ‘performance bias’.

This is to say they will usually be attracted to assets that have consistently done well and repelled by assets that have been volatile and have suffered falls in market prices.

Many still fear buying shares after the market crash in 2008/09 and are waiting for a repeat.

The US market since then is up over 300% from its lowest levels, so yes there will almost certainly be another crash at some point in the future but buying when the markets were depressed was a fabulous investment although a tough thing to do emotionally.

PROPERTY

By comparison most people who have owned property over the last 30 years have thoroughly enjoyed the experience.

From the Financial Market liberalisation of 1982 onwards (where mortgage financing became far less regulated and therefore easier to obtain) house prices have risen strongly, although they have been far more volatile than most now remember with falls actually greater in the 1990’s than the FTSE100 endured.

But the real growth (inflation was a big tailwind before) has really come in the last 20 years.

The U.K. does have a housing shortage and this is somewhat positive for prices, but undoubtedly the two main drivers of property appreciation in the 2000’s have been:

  1. Falling interest rates
  2. The surge in Buy to Let investors

We have written about this previously and the articles are on the website, so I won’t revisit the minutia of the property market and why we think it’s possibly about to enter choppier waters.

The headline risks however appear to be these:

  1. Interest rates have hit bottom; they can go no lower. They will absolutely rise from where they are now and this will make buying a house more expensive monthly. It is often said that even when they rise, rates will still be low by historical standards and this means there’s less danger. This is plainly wrong in that once the market adopts something as a ‘norm’, a strong variation from that norm is going to be disruptive. To argue otherwise is to simply ignore the maths. If rates double, it makes no difference if this is from 2.5% to 5% or from 5% to 10%, the increase in the monthly costs of debt servicing is exactly the same.
  2. Two year fixed rate mortgage rates are currently around 2.5% (or lower). If they peak at say 5% (which is not by historical standards even their average) this will make the interest element of a mortgage 100% more than it is currently. Incidentally this is pretty much what has already happened in the US and their property markets are starting to decline.
  3. For Buy to Let investors, a rise in rates will reduce returns as the costs of ownership rises closer to their net rental proceeds. Plus if prices start declining there will be a strong temptation to sell.
  4. If (and probably when) a wave of Buy to Let properties hit the market at the same time, this will have the opposite effect it had when investors were piling into the market to buy. On the way up, many properties were bought by people not selling which distorted the supply demand balance. Lots of buyers chasing fewer properties equals higher prices.

But:

Like loan leverage this works great on the way up and turns highly toxic on the way down.

All those Buy to let owners wishing to sell will equally not wish to buy.

The supply demand balance shifts to lots of sellers and few buyers, where prices come down to attract the sparse number of purchasers increasingly incentivised to wait and see who will cut asking prices the most.

In this scenario the areas that get hit hardest are the big developments (apartments) or housing estates where all the units are pretty much the same.

The only differentiator for these is the sale price and the lowest sells first.

Once a few sell at much lower levels, everyone sees this and it creates a new normal asking price from which discounts are demanded.

BONDS

Essentially the same dynamic as explained above is in play with any asset where they are bought based on a yield (interest rate return). The price is dictated by the yield investors can get in the bond market and the risk of losing their investment.

This is why Sovereign Bonds like UK Gilts (this is true, I initially typed Gits which actually sums up how I feel about U.K. politicians not the debt) or US Treasuries are the lowest yields because they are considered the safest in relation to getting your money back.

So if rates rise (which in the US they have by 10% plus over the last two months on the 10 year Treasuries), the price of the asset must fall to push up the return and reflect the new yield.

So basically any Bond in this scenario will suffer capital losses as rates rise.

WHAT FEELS SAFE

This takes us back to the point about ‘Investor bias’.

Most investors like bricks and mortar. It’s an asset that’s done wonderfully well for them personally, they feel they understand it and therefore have confidence in it.

Equally Bonds have had an epic run of success as interest rates have fallen over the last 20 years plus, so they are perceived as safe and low risk.

If interest rates rise strongly however, both these asset classes will absolutely without question struggle. There is simply no way that either won’t be negatively affected and prices will have to reduce to reflect higher interest rate yields.

CONCLUSION

One of the most important functions that we give our clients is providing information, observation and advice which adds different and sometimes challenging perspectives to their own thoughts and beliefs.

It’s certainly not the case that we want to or enjoy being contrarians to popular sentiments. In fact the Financial Services industry thrives on advocating things which have a current history of being successful, as most will be more inclined to follow this advice as they can see its success and therefore have greater confidence it will continue (investor bias used to sell investments).

It’s undoubtedly true however that the longer something has been good, the less and less the likelihood is that it will continue to be so – as prices overshoot fair value and the drivers for its success change from positive to negative forces. Inversely if something has been terrible (and is not broken) then it is more likely to improve as prices undershoot and negative factors abate.

Where in the case of say Property or Bonds this success cycle has been very long lasting, it’s especially tough not to be relaxed about its continuation but at some point it will reverse (everything does) and we believe interest rates are the key component to this.

Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.