CHAPTER 1
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It's a Financial Cycle - Get Over it: And Win
There is always a danger when setting out to change economic theory, or at least modify it significantly, that there is a bias towards the change that colours the view of the market overall. You will need to read âHindsight â The Foresight Sagaâ to judge whether that is the case here. However, the figures are compelling and the three historic timescales used are sequential and confirmatory. The driving force of any advanced economic culture is the banking system. It is the pulse by which much of human economic activity thrives or fails.
What has been revealed in this book is the interrelationship between the property and equity markets and their indisputable effect on the bankerâs ability to lend. Those interactions and those interactions alone create a classic marketTMwhich is broadly a fifteen year cycle of equity and property movements that are brought about by the availability or dearth of the bankâs ability to support property purchases or support the expansion of commerce. Couple that with the emotional factors of greed, fear and grief that attend every market rise and fall over time and you have the basis for a predictable financial cycle.
Does it take almost 300 pages to explain the theory? Certainly not, but it probably takes that number of pages to explain that there is no such thing as âit is different this timeâ because the conclusion that the research draws is that: it never is âdifferent this time.â
We have to conclude that politics is a powerful force which can accentuate the rise and fall, along with the duration, of any particular aspect of the market cycle but, what it cannot do and does not do, is change the cyclical integrity of the financial markets. The same âpatternâ emerges whatever the external forces appear to contribute.
If proof were needed then proof is here in this publication. The classic market makes financial fortune-telling a serious consideration with very real benefits in increased returns. What acknowledgement and, hopefully, adoption of the principals described here might also do is to smooth out the excesses in the movement of equity and property markets and thus lessen the effects of the âboom and bustâ syndrome that is associated with them. Bankers will become more pragmatic in their lending practices
There are pressures geared to performance and financial targets which manifest themselves in various ways, for investors and providers of financial products alike.
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The date was late October 2009. Autumn was closing in, the leaves were falling, the value of shares rising. The recession was in evidence (the longest recession since 1955) and the last âstructured productâ liable to offer 7.5% per annum return as an income over the next five years was on my desk.
There are a number of trustees, with Family Trusts, desperate to find a reasonable return on their investments without âundue riskâ. There are quite a number of individuals who in September, 2008 were earning 5% per annum on their deposits with banks and are now lucky to achieve 0.3%. Where can depositors, investors, turn with any certainty?
The correct word might not be âdesperateâ to find a better return, but rather more âanxious;â (perhaps bordering on âdesperateâ). When you have a duty to perform, as trustees do, things can get âanxious.â The trustees want to perform, however they are used to a âstatus quo.â Banks provide deposit accounts and (usually) pay a reasonable rate of return to depositors. Banks are âsafe.â Capital is available on request. Deposit accounts are what you and I, and trustees, are familiar with. However, what happens, psychologically, when things change is inertia sets in.
Can you remember the euphoria as you drove around âthe cornerâ and discovered the petrol station that had reduced petrol prices to below ÂŁ1 a litre? How soon we forget that the price was 65 pence a litre and that the government is taking a huge âturnâ on our money. We got used to paying ÂŁ1.12 per litre in a relatively short time span.
And now? It is forecast to rise to over ÂŁ1.30 per litre.
I was listening to Radio 4 recently and they were reviewing how they should accurately forecast the weather. The topic of the conversation centred on, âshould we be stating Fahrenheit or should the temperature for the forecast be in Centigrade?â
The broadcasters raised an interesting point: the weatherman said, that whether the temperature was given in Âș F or Âș C only mattered at the extremes. In other words, when it was very cold, minus two
(-2ÂșC) Centigrade was more relevant to our psyche (how we understand numbers and relate them to reality) than twenty seven degrees Fahrenheit (27ÂșF).
On the other hand twenty two degrees centigrade (22ÂșC) did not relate to how warm it was when compared to seventy two degrees Fahrenheit (72ÂșF). This is the result of perception despite both being the same level of coldness and warmth respectively.
So it is with market comparison. Many people are bewildered by terms that they are perhaps unfamiliar with and nervous of:
The FTSE 100
The house valuation index (Nationwide Building Society or Halifax Bank (HBOS))
The S&P GSCI-ER index (commodities)
The FTSE EPRA/NAREIT Developed Europe Index (Property)
From the sublime to the âcor blimeyâ I had never heard of the last one until that late October day when the leaves were falling and my mind was racing to understand more about how an element of âcertaintyâ could be instilled into providing the returns people required to fulfil their obligations.
What had been placed on my desk was an opportunity to satisfy the needs of the trustees and those anxious individuals within a very brief window. Here was an opportunity to utilise my knowledge of the market. Here was the relevance of âtimingâ and the certainty that an opportunity lost was an opportunity gone; not for ever, but gone, for probably twelve to fifteen years.
Let me explain.
This period of time (2009 â 2011) constitutes the last throes of a classic market. The classic market is something that I have defined personally in conjunction with many well rehearsed and learned economists and commentators âgiving forthâ on market cycles. The classic market is primarily a relationship between property and equity price performance â they are inextricably linked, as this book will illustrate to your advantage.
A fundamental link also exists between the stock market and property values and the lending power of the banks.
When you go into a new town and you get off the train, (bus, plane, or boat) and you walk out of the station; do you feel apprehensive in a new environment - a kind of nervous feeling? So it is when a new financial idea is âfloatedâ for your consideration.
It is true to say that when you have been in certain circumstances once or twice you become quite confident in the knowledge of where you are, and how to proceed. However, what if it is some time since you have been to Mansfield or Dublin, Lewes or Newcastle, Edinburgh or Gibraltar? You know what I mean? The confidence evaporates and you look out of the car; or walk out of the station. The familiar territory has changed. That is what happens over the course of a classic market; familiar territory changes constantly, but as I hope to convey throughout this book, the changes conform to a recognisable and predictable pattern.
If you know where you are (in time) you can be confident. A feature of the classic market is that in some stages it is a âcapitalâ orientated environment. Investors are chasing capital gains. The stock market has usually moved ahead quite dramatically, like the January sales - everybody suddenly starts heading for the bargain basement except that the storekeeper has very often âseen you coming,â waited for the rush and changed the products on the shelf.
The bargains are not that good value anymore, but still people buy them on the basis of perception rather than fact; after all it is a sale, therefore the items must be good value â better value because after the sale the price will rise. A bubble can easily be created and when the bubble bursts individuals, still convinced there are bargains to be had, look elsewhere.
Property is usually the target of a professional investorâs attention when the stock market looks vulnerable. The experienced eye will detect any market alteration first. When the bargain basement of shares is shunned by the experienced shopper, the novice remains and even intensifies their position in that marketplace. They buy more shares because recent history shows the price rising to confirm to the novice that gains can be made.
The property market will have been static, for a long period perhaps four or five years and then it starts to rise exerting itself for reasons that we will discuss later on. However, the âchase is onâ and the âbargainsâ become irresistible.
As the stock market careers downwards, so the residential property market initially, and the commercial property market in its wake, move inexorably upwards, supported, and even encouraged, by the banks - and of course governments, because both banks and governments love the people to have the âfeel good factorâ that owning something of value imparts.
Does this all sound familiar?
Possibly not; because, as I will explain, a lot of people, a lot of the time, are just not in that mental space that makes any of this relevant to them. The stock market is not something that they, as individuals, consider themselves invested in, not consciously anyway. The residential property market is irrelevant to young adults who may still live with their parents or are content in rented accommodation because they may be involved in higher education or require the flexibility to move to a fresh location at short notice with their work.
There are many individuals who did âall thatâ long ago. They are firmly in their home; it is all paid for and everything else is irrelevant to them. Property values only become relevant when the incumbents want to move from their own home or they want to exercise âequity releaseâ and raise money from their home. Equity Release is something that we will discuss later.
The real driver in this leap for capital growth through property ownership, particularly where commercial property is concerned, is the rental income generated by the property through increasingly reliable tenants chasing low levels of rent for new or expanding business propositions that banks will support through short term loans and overdraft facilities (often secured on the private dwelling of the entrepreneur).
In this part of the classic market then, there is an inverse relationship between shares and property. As shares are going down in value the property market may be going up. Why would that be so?
The collapse of the stock market during this phase of the cycle is not about mainstream business failure. No, it is about the adjustment of the market value of the shares in businesses following a period of mild hysteria that drives share prices beyond their âreal (perceived) value.â
Businesses can function at a normal level in this environment because the banks have the financial capacity to provide them with financial support using their property as security not necessarily for individual bank customer loans but because of the collective, universal multiplying counterbalance of property values and the knock-on effect that has on bank asset ratios (the banksâ solvency margins).
At any point in time a bank could multiply its cash asset base and lend out everything it had on deposit eleven times, and count the equity in real property in for the multiplier. The equity in this case is the difference between the loan (mortgage) and the underlying asset value.
As the property market rises the security held within the banking system grows in value. The bank has more and more resource (money) to lend out. Thus support or even an upward spiral presents itself as a mechanism of business expansion even though the stock market would be in free-fall.
Why was it different in 2008; at the other end of the classic market? The catalyst for that change of focus was linked to property values.
The UK banking system had simply lent too much secured onto a now shrinking value base.
It is perhaps at this point that it becomes apparent to people in authority, who really should have known better, that a reduction in property prices affects the ability of banks to lend money. It also affects the support for the banksâ own balance sheets in the process (the banksâ solvency margins).
Banks lend money on the basis of a multiple of their âcashâ asset base. In other words for every pound that the bank has physically, or by way of equity in security as a mortgage, or other collateral agreement, the bank could lend that money out eleven times, up until September 2008. The rules are tighter now.
By the end of 2008 the government was in the process of changing the rules. Basel III was on the table as Basel I and II had been held to have failed. The Regulator had tightened the screws, property values were sliding with increasing speed and businesses in difficulty found their financial support from the banks evaporating. Businesses during this phase of the market cycle were experiencing a shrinking market, shrinking asset values and shrinking support from the banks accompanied by panic at government level. Armageddon was imminent!
In reality it was not Armageddon. This was a normal, predictable set of circumstances repeating themselves, but who could remember that far back: to the last time. Hindsight had become âshort sight.â For every million pounds that property values sank the banks had to âclaw backâ ÂŁ11 million in cash to support their own balance sheets.
The result was a complete correlated drop in value of both property and equity prices largely due to the fact that banks headed the financial sector in the main share index and as the bank shares dropped, confidence in the market as a whole waned therefore other share values followed suit. The market sentiment changed so rapidly many institutions were caught out.
What has that got to do with a late autumn day in October, 2009? - Everything!
The opportunity that arose on that October morning stems from the fact that somebody had been smart enough, astute enough, lucky enough, to have put together a structured (we will talk about the definition of that later) product that had an underlying interest rate of 7.5% per annum paid monthly as a very tax efficient income source. The contract was linked to any one of three indices (measures of price movement within a particular market):
One linked to the possible fall in share prices, by 50% or commodities or property under the same terms.
What was on offer was a contract, paying 7.5% per annum on a monthly basis over the five years, subject to certain market criteria. The banks and building societies were paying less than 1.4% at the time.
Was there a possibility of any of those indices, shares commodities or property devaluing by half (50%) during the five year period?
The odds had changed the view of the future and the structure of the products was moving into a different regime. This was not gambling, it was a carefully calculated mechanism put in place, with a set of known returns being juxtapositioned against a statistically probable outcome in order to generate a defined return.
First of all: the structure was based upon a five year term. The second premise was the possibility of a 50% reduction in the FTSE 100 index (shares...