The power of indexation
Fund managers typically invest in the major stock market indices, and most of these decisions are made automatically by trading algorithms. Scary but true!
Not all portfolios are the same. There are countless investment styles which keep the game interesting, but regardless of the strategy, Australian fund managers typically invest in the S&P500 and ASX200 indices because they are solid markets. The ASX200 is an index of Australia’s Top 200 publicly listed companies and the S&P500 is America’s Top 500.
Emphasis on the word ‘Top’
Using the ASX200 as an example, if the market capitalisation (a.k.a. size) of Company #201 grows larger than Company #200, it takes its place, and Company #200 is removed from the index. If you’re into sports, think of it as being relegated from the Premier League.
Over time, the sum value of these indices grow at an impressive rate. Share markets are never at the mercy of affordability, sentiment, or inflation because they consist exclusively of the biggest and best companies at any given time. As soon as a company fails to retain its position in its index, it gets kicked out. Pretty brutal for the outgoing company, but very reassuring for the investors, most of whom are pension funds around the world relying on solid performance to fund their clients’ retirements.
There’s no such thing as the ‘Property500’ index
Most the world’s real estate is privately owned, and not available for the public to invest. Property is illiquid and far less frequently traded than shares. In one sitting you can instantly sell a share in a company and chase a better return on a different company based on a universally accepted formula determining the price of a share. But you wouldn’t sell just one brick from your house, and even if you did, you can’t electronically transfer it, and there are no widely accepted formulae determining the price of bricks.
If there was such thing as the Property500 index, it may well outperform the share market. But there isn’t, and never will be. Would you allow a Wall Street fund manager to sell shares in your property to Greek pensioners? Would you like it if a Russian oligarch owned 100% of your family home? What if Kim Jong Un owned your entire suburb? No-one would ever allow this.
Property prices tend to narrowly outperform inflation over time
Given the frequency and volatility of trading in the share market indices, share markets tend to ‘boom and bust’ – the average trendline of growth is around 10-12% per annum.
Conversely, most property markets tend to ‘rise, plateau and dip’ – with an average growth rate of 4-6% per annum.
What ignites a property boom is a period of underperformance, followed by housing undersupply, cheap credit, and a loosening of fiscal policy allowing people to borrow like crazy. This is exactly what happened in the onset of the COVID-19 pandemic which sent property prices soaring. But if you think this is going to continue, then you have not considered the unapologetic reality of property markets. Do not be fooled into the permanence mindset.
Affordability: The Inescapable Limitation
Regardless of whether we are in boom or plateau cycle, we cannot escape the fact that property prices will always be at the mercy of affordability. If a property owner can afford $3k per month in mortgage repayments, and her interest rate is 6%, she has a theoretical borrowing capacity of $600k. If interest rates go up, or if inflation persists, her borrowing capacity goes down and so do property prices. No amount of population growth, local infrastructure projects, jobs or housing undersupply changes this equation.
Of course, there’s more to it than that.
Property markets are among the most interesting and complex markets to track. There will always be areas that are performing, areas that aren’t and areas that are more-or-less plateauing. But each area is always at the mercy of affordability, bar none. I’m not expect property prices to crash, but I don’t see much growth on the ten year horizon either. Most markets will perform close to the rate of inflation.
As it currently stands, all the data is saying that disposable income is plummeting nationwide.
Share markets care not for affordability
Even with no new money flowing into share markets, they can still boom, because companies in the ASX200 and the S&P500 make things and sell them… for trillions of dollars, every year, regardless of economic conditions. The biggest companies in the world being banks, technology firms, natural resource providers, healthcare and supermarkets continue to operate and make multibillion-dollar profits even in the most recessive of markets. This is because they make the things we need to survive. It’s a volatile market, but it performs well over the long term. Always has, always will.
My investment stance
I remain steady on property and defensive on shares.
While I believe the property market will outperform the share market for immediate term (next 12-18 months), I believe the share market will return to dominance for the vast majority of the decade that follows.
Now is not the time to choose sides. It is the time to stay liquid, diversified, and nimble.
Source: Historical data: ABS, https://www.macrotrends.net/ | Future data: Bryce’s imagination (please don’t rely on this!)
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