Will a fall in property prices cause a stock market crash?


Numerous media commentators have been alluding to the looming possibility of a property price collapse in Australia, and it’s not just because Sydney house prices have gone through the roof. Given the record growth in residential real estate spanning 55 consecutive years, investing in property has been lucrative. But many are pointing to the potential threats of rising interest rates, high personal debt levels, low wages growth, tougher sector regulation and political indoctrination on improving housing affordability as potential reasons why the sunny days for property investors may soon be over.

In comparison to other countries, Australia is the seventh most expensive place for real estate investors, with a ‘dwelling price to average income ratio’ of around 8.4 times.

property

Adding to fears of an imminent collapse is the softening of clearance rates over the past year as tighter lending standards by the banks and restrictions on foreign investment buyers begin to kick in.


Source: CoreLogic

Further, according to CoreLogic, a boost in property prices over the last few years has compressed the average residential income yield, dropping at the end of October 2017 to 3.1% for house rentals and 3.9% for apartments. This makes real estate close to the yield of cash assets, and a much less attractive proposition to the stock market from an income perspective, which is currently on an average dividend yield of around 5%.

However, despite the binary nature of shares vs property, the two have exhibited a strong correlation in the past. Therefore, many investors watching from the sidelines are wondering whether a downturn in the property market would impact upon the returns from their share portfolio.

Is this the right question?

Before we consider whether a property crash would result in the same for the stock market, perhaps we should consider whether this question is relevant.

Historically, share markets will react far more quickly to a property downturn as the share market is a leading indicator of investor sentiment.

If the possible macro-economic headwinds described in the introduction start to come to fruition, then the likely impact will be felt by share investors well before property investors experience the full brunt of any declines. This is symptomatic of the share market being far more liquid than property. Unlike real estate, investors in the share market can quickly withdraw funds for cash, in a flight to safety. This is in contrast to the property sale process which can take upwards of three months to complete, with a further three months to settle. Furthermore, property tends to be more ‘sticky’, given that people need a place to live. According to the Australian Bureau of Statistics, home ownership accounts for around 70% of all residential investment, making it far more unlikely that people will sell their home.

But, in most part, it is the enhanced liquidity and ‘predictive nature’ of the share market that can lead to significant short-term volatility. Worse still, the market is not always right. In fact, there is a joke amongst many long-term investors that the market has, “accurately predicted three of the past ten recessions.” Highlighting how in the short-term, the market can move savagely on a doomsday expectation, only to rebound rapidly once things have settled down.

Therefore, the question investors should be asking themselves is whether a downturn in the property sector will affect businesses in their share portfolio.

Which business sector will be impacted by a property market correction?

As seen in the past, a prolonged and significant downturn in the property market can have a markedly detrimental economic impact. No one need look further than Japan whose property crash of the early 90’s fuelled a recession that lasted almost two decades.

Within the share market, the businesses that would be most affected are those in the following sectors:

  • Financials
    • Australian banks have 45% – 65% of their business1 exposed to the property market in the form of lending. Lending levels are linked closely to the value of assets.
  • Building and construction
    • As the second largest industry in the economy accounting for 8.1 per cent of GDP2, the impact on developers and building materials businesses would be significant.
  • Real Estate Investment Trusts (REITs)
    • Revaluation of assets is a key driver for REITs. Should values plummet, so will their share price.
  • Consumer discretionary
    • Individuals are likely to feel ‘less well off’ if the value of their major asset declines. The impact is reduced consumer spending, impacting retail businesses.

Although, there is also a much wider impact to the economy, weaker consumer spending will inevitably flow onto business confidence and result in rising unemployment and reduced investment. A slippery slope then ensues which can often drag all stocks, including the great businesses down with it, just as we experienced during the world’s most recent property related share price correction, the Global Financial Crisis (GFC).

Don’t panic. It’s proven – quality rebounds first!

After a broad market sell off, high quality stocks tend to outperform the rest of the market. This is because once the dust settles on a broad correction, the money flows back into the quality businesses first, as they represent the best value.

As an example, following the GFC, from February 2009 to February 2010, the ASX All Ords increased 32%. At the same time (in February 2009,) eight Lincoln Star Growth Stocks were introduced (in February 2009). As a collective they averaged a return for the year of 79%, with only one, Resmed Inc (RMD), underperforming the market. Rather than attributing the rise to any macro-economic factor, we attest that the strong returns were a reward for investors who remained proactive during that difficult time and could seize on the wonderful opportunities the broader market delivered to us.


Data source: Lincoln Indicators from Feb 2009 to Feb 2010

When we extend logic to our full list of Star Growth Stocks, the returns are even more impressive. Inclusive of dividends, Star Growth Stocks returned to the peak of November 2007, well within three years. The All Ordinaries Accumulation Index on the other hand was one month shy of six years.  That was a 1,101-day difference, which by that time Star Growth Stocks had returned 54% more than the market’s previous peak. Refer to the graph below.


Source: Lincoln Indicators

Stock Doctor – the recipe for long term success

At Lincoln Indicators, we believe being disciplined and holding great fundamentally healthy businesses are the keys to success in the long-term regardless of market conditions. This is no better exemplified than by the long-term returns of our Star Growth Stocks.

A significant correction in the property market will no doubt have an impact on businesses, and not just the broader share market sentiment. However, investors tend to be irrational during these volatile periods and many high-quality stocks will be sold down unfairly despite their resilient growth profile.

We believe volatility creates an opportunity for investors who have the means and tools available to help them pick these high-quality stocks at reasonable prices. And though we do not know when the low point of the share market will hit, we will know when we miss it. History tells us that holding the very best quality businesses gives us confidence, knowing that when the market recovers, these high-quality businesses would be the first to respond. Long before any market or property recovery.

Article also published in The Australian Financial Review 

Our guide to establishing and implementing a successful investment strategy
The Golden Rules for successful share market investing
How the Financial Health Model can work for you

1Source: Lincoln Indicators
2Source: Australian Bureau of Statistics
All figures, information and illustrations are as at 4 December 2017 unless stated otherwise.
#Source: Lincoln Indicators

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