Friday 1 January 2010

UK Property Market – December 2009 Update




I am yet to buy myself a flat or house even though the ownership of one is important to my retirement investing strategy in the longer term. The reason for this is in my opinion UK property is overvalued by a huge margin. Although given the press reports I sometimes feel as though I am the only one in the UK who thinks property can go up as well as down. Chart 1 shows compared to average earnings that property is very expensive when a ratio is created of the Real Nationwide Historical House Prices to the Average Earnings Index (LNMM) and it is for this reason I have yet to buy. In 1996 this ratio was as low as 607 and today the ration stands at 1,188. If we were to return to that number the average house using the Nationwide Index would be £82,929. Will we ever get that low again?

Yesterdays BBC headline states ‘House prices rise by 5.9% in 2009, says Nationwide’. I guess it depends on how you look at the data. According to my interpretation of the Nationwide data set house prices fell by £661 over the past month.

Chart 1 also shows Nationwide Historical House Prices in Real (ie inflation adjusted) terms. I’d like to compare it to Chart 2 above. Is this small decrease a one off or is it the ‘Return to “normal”’ phase of Chart 2 kicking in? Only time will tell but I’m still out for now.
Chart 3 shows the annual change in Nationwide property prices and compares this with the change in the average earnings index extrapolated a couple of months to match the Nationwide time period as LNMM is still only released to October 2009. It shows that on an annualised basis average earnings have turned negative at -1.7% while house prices continue upwards at that BBC quoted 5.9%.

That said, I think Chart 3 also shows clearly the problem we have. Since 1991 the UK Retail Prices Index (RPI) has averaged 2.8% annually. The Average Earning Index has averaged 4.1% for a real increase over inflation of 1.3%. What justifies this 1.3% - have we become more efficient? Now here’s the problem. The Nationwide dataset has increased by 5.8% annually for a real increase of 3% over inflation. How can this be? Has it become so expensive to build a new house? I believe the answer is no. It is pure asset price inflation. Of note also is that as time has progressed the trend line for house prices is heading in an upwards direction.

What’s causing this? I believe that when an economy is run with too loose a monetary policy you will see increases in one of two places – either inflation for goods / services will kick in or you will get asset price inflation. Our supposed experts who control the economy only look for the first one and control interest rates based on this. What we saw this economic cycle was inflation controlled with no care for the huge asset price inflation that was occurring. This has meant extraordinary bubbles in property, share markets and even commodities (what was oil $147 barrel?). These markets then started correcting themselves and we started to see asset price deflation. How have our experts responded? With even looser monetary policy which is resulting in new bubbles inflating in share markets (I showed yesterday that the S&P 500 is already at its 80th percentile based on historic data) and property. Why do they not try and control inflation with interest rates but value asset prices (for example, the Shiller PE10 has a good correlation with prices and could be used for share markets, ratio of prices to earnings could be used for property) and control this by, say, changing banks minimum capital ratios as suggested by Smithers? Maybe this would stop the large boom and busts we have seen in recent years.

With inflation now kicking off will the Bank of England increase interest rates and stop this property boom or will they allow inflation to occur at the expense of savers? Right now I’m backing the second and so I will protect myself with inflation linked products wherever possible.

Thursday 31 December 2009

US (S&P 500) Stock Market – December 2009 Update



To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted Price / Earnings (PE) ratio for the S&P 500 to attempt to value the US (specifically the S&P 500) Stock Market. The method used is that developed by Yale Professor Robert Shiller. My numbers will always appear slightly different to Professor Shiller as I also use the Earnings forecasts from Standard & Poors to complete the data set up to the month of interest. I will call it the Shiller PE10 and it is the ratio of Real (ie after inflation) S&P 500 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings. I will use this data set as a proxy for my UK Equities as well as my International Equities (mostly Japan, US and EU equities). Ideally I would create a PE10 for each country however good data is impossible to find and I am working on the principle that these stock markets are now heavily correlated with globalisation.

To give an example of this I have just read a very good book called Wall Street Revalued by Andrew Smithers. He presents data that shows the following stock market correlations for the period 1999 to 2008:
US to France, 0.92
US to Germany, 0.93
US to Japan, 0.84
US to UK, 0.93

I will assume that stocks always return to their long run PE10 average and so reduce my exposure when stocks are overvalued and increase my exposure when they are undervalued. For my US and International Equities I will use the long run average of the Shiller PE10 to equate to when I hold 21% UK Equities and 15% International Equities respectively. For my retirement investing strategy on a linear scale I will target 30% less asset allocation when the Shiller PE10 average is Shiller PE10 average + 10 and will have 30% more asset allocation when the Shiller PE10 average is PE10 average - 10.

All figures are taken from historic data provided by Professor Shiller. Current stock market data is taken from Standard & Poors and inflation from the Bureau of Labor Statistics. The December market price is the 30 December S&P 500 stock market close.

Chart 1 plots the Shiller PE10. Key points this month are:
Shiller PE10 = 20.6 which is up from 19.8 last month. My UK Equities target asset allocation is now 18.3%. Additionally my International Equities target asset allocation is now 13.1%.
Shiller PE10 Average = 16.4
Shiller PE10 20 Percentile = 11.0
Shiller PE10 80 Percentile = 20.6. This means the S&P 500 is currently sitting right on the 80 Percentile.
Shiller PE10 Correlation with Real (ie after inflation) S&P 500 Price = 0.78

Chart 2 plots further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the Shiller PE10 value.

Chart 3 plots Real (after inflation) Earnings and Real Dividends for the S&P 500. Real Dividends are still falling however they are still above their long term trend. Real Earnings have a roller coaster ride continually, particularly since about 1990. If the Standard and Poors forecast earnings are to be believed however we are now back above the long term earnings trend.

Wednesday 30 December 2009

US Inflation – November 2009 Update

The above chart shows the Consumer Price Index (CPI-U) up to November 2009 courtesy of the Bureau of Labor Statistics. I have taken the liberty of dividing the chart into two sections. The first red section runs from 1871 to 1932 and the second blue section runs from 1933 to present day. I chose this break point as during 1933 the US officially ended their link to the gold standard. I think this chart demonstrates a point that government will always choose to inflate debt away at the expense of savers if given the chance. They could not do this under the gold standard. To demonstrate this average inflation rates have been:
1871 to 1932, 0.5% with deflation being a regular occurrence.
1933 to Present, 3.7%

Tuesday 29 December 2009

Australian Stock Market – December 2009 Update





To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted PE ratio for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 average is ASX 200 PE10 average + 10 = 26 and will own 30% more stocks when the ASX 200 PE10 average is PE10 average -10 = 6.

All figures are taken from official data from the Reserve Bank of Australia except December which is estimated by taking the price from the 28 December Market close. Additionally the December Dividends and Earnings are assumed to be the same as the November numbers.

Chart 1 plots the ASX 200 PE10. Key points this month are:
ASX 200 PE10 = 18.7 which is up from 18.5 last month. My target Australian Equities target is now 19.3%.
ASX 200 PE10 Average = 22.9
ASX 200 PE10 20 Percentile = 17.3
ASX 200 PE10 80 Percentile = 27.7
ASX 200 PE10 Correlation with Real ASX 200 Price = 0.82
Chart 2 plots further reinforces why I am using this method. While the R^2 is low there appears to be a trend suggesting that the return in the following year is dependent on the ASX 200 PE10 value.
Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends appear just about on trend however Earnings are still struggling and heading very much downwards. If this continues and Prices hold the ASX 200 PE10 will surely start to rise.

Monday 28 December 2009

UK Inflation – November 2009 Update



The Office for National Statistics (ONS) reports the November 2009 UK Consumer Price Index (CPI) as 1.9% and the UK Retail Price Index (RPI) as 0.3%.

On the surface this sounds ok as the Bank of England has the following remit:
“The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment. Price stability is defined by the Government’s inflation target of 2%.” The inflation measure they use is the CPI and so why would they raise interest rates?

I however don’t like what I see when I look at the raw data and think inflation could quickly get out of hand given the very low interest rates and quantitative easing that is currently occurring.
The first chart is tracking the CHAW Index which is the RPI including All Items. I focus on the RPI as my National Savings and Investments Index Linked Savings Certificates use the RPI to index from. This saw a big dip when the Bank of England dropped interest rates to historic lows however the chart shows that all the dip did was compensate for the big kick upwards that was seen from 2007. The current level of the Index is just about on the trendline suggesting we are back to the average annual increase since 1987 which is around3.5%.

The second chart is again based on the CHAW Index. This chart shows annual figures based on the previous 3, 6 and 12 month’s worth of data. As of November the 12 month figure is 0.3% (as published by the ONS) however disturbingly the 6 month figure is 3.6% and the 3 month figure is 4.1%. It will be interesting to see the official January 2010 numbers which is 12 months from the low in the Index at January 2009 and whether the Bank of England does anything about it. My simple projections suggest this could be up to 3.7%. I’ll keep buying Index Linked Savings Certificates whenever possible if this is going to continue.