Hamilton Bolton founded the Bank Credit Analyst research company (now known as BCA Research) in 1949. He and Ralph Elliott corresponded and shared similar views on how markets cycle. After studying a history of major depressions, Bolton concluded that the one aspect they all had in common was a deflation of excess credit. At some point, a build-up of excess credit, therefore, becomes a clear warning sign that an economic downturn is a significant risk.
Australia has seen household debt increase by huge amounts over the past three decades, most of it being related to residential mortgages. As our chart below shows, household debt as a percentage of income was fairly stable between 35% and 45% during the 1970’s and 1980’s. In 1988, it leapt to around 60%. Since then, the rise has been stratospheric with the latest figures showing that, at 193%, Australian households have nearly double the amount of debt than income, by far the highest in the G10.
This debt has been piled on thanks to the boom in Australian residential housing. Social mood has trended positively, enabling at various points a thriving commodities sector and lower interest rates, contributing to the overall feeling that buying houses is a great investment. In fact, a mania has developed in multiple property ownership. According to the Reserve Bank of Australia, the number of investors with five or more (!) properties grew by 7.5 per cent between 2014 and 2015. That’s almost double the rate of growth over the previous nine years. Two million people have investment properties, over one in ten of the adult population. Over one million people have two or more investment properties. Adverts abound on how easy it is to become a property investor, no matter how low your income is.
Is it a bubble?
The term “bubble” derives from an old English word for profit. The profit that came from a deal was called “the bubble” and the term “double bubble” is still used regularly today in London to describe extra pay or profit. Nowadays, a bubble is thought to be an overvalued market but, to use the original definition, it could describe any market that gives its participants seemingly endless profits. Defining a bubble can be a contentious and, frankly, futile task. Many people think the Australian property market is not a bubble, just as many people thought the Nasdaq was not a bubble in 1999. Our view is simple, if there’s excess debt / leverage and seemingly one-way thinking at play, it’s a bubble.
And, as our chart of Australian Household Debt as a Percentage of Income shows, there is a good chance that, since 2013, the Aussie debt binge has been in a fifth wave. Fifth waves are characterized by speculative behavior which would fit a bubble description.
It’s one thing identifying a bubble or excess debt situation. It’s quite another thing to identify when that bubble may burst. This is where the simple discipline of trend following works well. When a bubble is occurring, utilizing a simple trend following methodology will keep you invested as it goes exponential. But this simple trend following methodology will also tell you when the bubble is bursting or at risk of bursting.
Let’s take a simple trend-following methodology, using a combination of long-term and shorter-term trends. We can measure the long-term trend as the slope of the 200-day exponential moving average (DMA) – with the slope being calculated as the current value minus the value 20 days ago. We can also measure a shorter-term trend as the position of the 5-day moving average relative to the 40-day moving average.
For bubble identification purposes we can establish the following conditions:
200 DMA Slope Up & 5 DMA above 40 DMA = Bubble Inflating
200 DMA Slope Up & 5 DMA below 40 DMA = Neutral / Bubble at risk
200 DMA Slope Down & 5 DMA above 40 DMA = Neutral / Bubble back on
200 DMA Slope Down & 5 DMA below 40 DMA = Bubble Deflating
These conditions tell us that, if the long-term trend and the shorter-term trend are both going up, the bubble is still inflating. If, however, the long-term trend is up but the shorter-term trend is down, the bubble is at risk of deflating and should be considered neutral. The bubble can be considered to be deflating when the long-term and shorter-term trends are down.
Sometimes, bubbles burst quite quickly, meaning that a crash can occur before the long-term trend measurement has a chance to turn down. The beauty of this methodology though is that it gives advance warning that the bubble is in danger.
For instance, taking a few bubble examples from history, this methodology would have told the observer that the Dow Jones Industrials index was “neutral / at risk” on 24 September 1929, over a month before the infamous Wall Street Crash in October 1929. It would also have warned investors not to be long the Dow Jones on 8 October 1987, over a week before the 1987 crash. Japan’s bubble was deemed to be “at risk” on 19 February 1990, after which the Nikkei collapsed by 25% over the next six weeks, and was deemed to be deflating in July 1990 when it plunged by another 37% into September of that year. Under this methodology, a warning sign would have flashed up for the Nasdaq on 3 April 2000, before the index crashed 28% into May, and was on and off deflation mode from October of that year until March 2003, after which the Nasdaq bubble had deflated by another 60%. The 200-day moving average of the Dow Jones Industrials started sloping down in January 2008, and so this methodology not only warned that the previous credit related bubble was “at risk” but that it was, in fact, deflating well before the dramatic falls, coinciding with the demise of Lehman Brothers, later that year. We could go on.
The message should be clear — although Elliott wave analysis is the best at it, predicting exactly when bubbles burst is almost impossible. But using price action to guide us into being positioned for such an event is entirely possible.
So what about the Australian property bubble? Firstly, we need to establish a good indicator that reflects the bubble. For the Australian property market we can create a basket of selected share prices that are representative of what is going on. We have picked five shares comprising property groups and building materials: LendLease Group (LLC AU), Mirvac Group (MGR AU), Stockland (SGP AU), Adelaide Brighton Ltd (ABC AU) and CSR Ltd (CSR AU). In the last three years, as Australian household debt has started to accelerate again, this basket of shares has gone up by 56% in price terms, compared with a 9% return from the Australian stock market in general.
So our lead indicator of an Aussie property crash is going to be this basket divided by the general Australian stock market –– the relative performance. It’s then a matter of employing our simple trend following methodology classifications to establish whether the bubble is inflating, neutral or deflating.
As the chart below shows, the relative performance of our selected property shares basket is trending higher, with an upward sloping 200-day moving average. It’s not shown, but the 5-day moving average has just fallen below the 40-day moving average.
So, at this juncture, our methodology concludes that the Australian property bubble is currently neutral and at risk of deflating.
It’s a fluid situation, of course, but you can keep up-to-date with our Aussie Property Crash Indicator here on deflation.com.