Betting against a housing bubble

Property Observer

Today I want to talk about our $100 million housing challenge to US fund manager Jeremy Grantham.

Grantham has argued that Australia suffers from the mother of all housing bubbles.

In his latest newsletter Grantham makes the point that optimists don't like to hear bad news.

"Tell a European you think there's a housing bubble and you'll have a reasonable discussion. Tell an Australian and you'll have World War III. Been there, done that!" Grantham wrote this week.

When Grantham first aired his remarks about an Australian housing bubble in 2010, we at Rismark challenged him to put his money where his mouth was (Our $100m bet for Grantham, November 8, 2010).

Specifically, we offered to work with Grantham to help him to 'short' – or bet against a fall in the value of – one of our national indices over the ensuing three year period.

In order to do so, we would have to find a counterparty to take the other side of this transaction: ie, some individual or institution that wanted to effectively go 'long', or lock in the future returns associated with our index.

One blogger recently claimed, incorrectly, that we intended to take the other side ourselves. Our original article demonstrates that this was not, in fact, the case:

"To be clear, Rismark would need to work pro-actively with Grantham to construct this transaction," it said. "We believe we have counterparties that would likely be prepared to contract with him. But it may take several months to facilitate (and cannot be guaranteed).

"Before we can proceed, we require a firm, contractually-binding commitment from Grantham that should we be able to facilitate this transaction, he will indeed act on the advice that he's offered to the rest of the world by committing a tiny fraction – less than 1 per cent – of his capital to his predictions.”

How would Grantham have fared had he backed his own rhetoric? The indices that RP Data and Rismark produce for trading purposes are 'total return' benchmarks, much like the ASX All Ordinaries Accumulation index, which tracks changes in capital values and dividends.

Since the end of October 2010, when we first outlined this idea, RP Data-Rismark's capital city accumulation index has risen by about 0.2 per cent.

So using this benchmark, which is the most likely index that a counterparty would wish to trade against (given they'd be expecting the capital gains and rental income realised from Aussie housing), Grantham would be down around $200,000. Call it evens.

If, on the other hand, he wanted to use the RP Data-Rismark index that follows changes in capital values, Grantham would be up about 5 per cent assuming we could have found a counterparty willing to ignore incomes (or rents).

Of course, the proposed transaction was over a three year horizon, so we are only 40 per cent of the way through it. And given that a national house price index has annual volatility of 5-6 per cent, we are still within the realms of what one might expect to see. Much like those analysts who predicted six Reserve Bank rate cuts to a 3.5 per cent cash rate by June this year, it would be highly imprudent to bank profits that have yet to be crystallised.

It is certainly true that we devised this bet at a deliberately attractive juncture for the bearish Grantham. It followed the RBA slamming the housing market with a surprise double interest rate hike in November 2010, which we forecast could put downward pressure on house prices over 2011. And that is indeed what transpired with the help of some additional RBA jawboning.

The good news for Grantham is that this opportunity still exists. So while he did not have the courage of his convictions when we first proposed it in late 2010, he can still put the trade on today.

Following media coverage of our idea, Grantham did personally contact my brother-in-law about it, and GMO officials requested a meeting in Sydney. Independently, I also received some email enquiries from GMO's head office in Boston. Curiously, when I actually met with GMO's executives face-to-face they made it clear they did not personally subscribe to Grantham's relatively extreme positions.

Nevertheless, in the event that Grantham still believes shorting Aussie housing is one of the best investments of all time, we would love to hear from him…

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.

This is an edited version of an article which first appeared on Property Observer on February 29. Republished with permission.