Hindsight The Foresight Saga

By Terence P O'Halloran

There is something new in the financial planning world and it is explored to the point that the reader can exploit it in “Hindsight – The Foresight Saga.” Little has been written about the property market and its relationship with the equity markets or the coincidental relationship that that investment relationship has on bankers.

This book is aimed at the private investor but also the professional investment manager because it highlights the mechanism that provides for an almost continuous steady flow of positive returns on invested capital and regular savings.

The author is a well experienced, highly qualified strategic financial planner and the language used in the book is straightforward and down to earth. The classic market™ is identified as a circa fifteen year cycle of at one point inversely correlated market movements that works in direct contrast to a later phase in the classic market TM where property and equity movements are highly correlated in a downward slide. The first having an extremely positive effect on banking and the second, a devastating effect that contributed to bank collapses similar to those in 1979, 1992 and 2008.

• Language: English
• Publisher: M-Y Books
• Release date: Oct 13, 2009
• ISBN: 9781907556074

Book preview

Introduction to the book

It would be very easy to trivialise theclassic market ™ by just stating blandly: this is the way it works and here are the indicators and now get on with it. But it is not actually as simple as that.  There are many myths and misconceptions which, if they are not explored, investigated, explained and put in their place still persist in the background to encourage the well known phrase it’s different this time to prevail.

One of the primary objectives of this book is to prove that it is never different this time, or any other time.  Fundamentals, it seems, prevail.

Much has been said about the political influence that can override economics and change the character of markets.  Certainly political influence needs to be explored, analysed and its relevance noted. However, if politicians can use the classic market to their own political ends then the investor can do likewise by adopting simple analysis techniques and applying them in an appropriate way. Hindsight -The Foresight Saga endeavours to give you, the reader, the tools to make that work in your favour.

There may well be elements of the text that you feel are ‘over the top’ or irrelevant, hopefully they will be few and far between. If you do find any section too political, too forceful then all that is asked of you is: please persevere. A lot of thought has gone into the inclusion of every story, case history, political nuance, conspiracy theory and statistic.  It is all there to ensure that it’s different this time does not come into play in your thought process when it matters – at the point of investing or starting a savings plan (or at the conclusion of the investment/savings period). 

The success of your investment and your saving for your future and the optimisation of the returns that you are able to achieve are here for you to take on board and profit from.  Believe me, it is worth the effort to make your future a more certain and prosperous place.

Terence P. O'Halloran B.Sc.

Chartered financial planner

Fellow of the Chartered Insurance Institute

Associate of the Institute of Financial Planning

February 14th  2011  The 35th Anniversary of O’Halloran & Co

Other titles by Terence P.O’Halloran still available include:

Trusts - A Practical Guide  (2nd Edition)

Mountains out of Molehills

You Sign (the little cheque and we sign the big one)

If Only Politicians Had Brains

Building a Business on Bacon and eggs

The Fight for our Post Office

CHAPTER 1

  - 

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 Hindsight – The Foresight Saga 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 banker’s 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 bank’s 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 it is different this time because the conclusion that the research draws is that: it never is different this time. 

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 ‘pattern’ 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 ‘boom and bust’ 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.

………………

 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 ‘structured product’ 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 ‘undue risk’.  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 desperate to find a better return, but rather more anxious; (perhaps bordering on desperate).  When you have a duty to perform, as trustees do, things can get ‘anxious.’  The trustees want to perform, however they are used to a ‘status quo.’ Banks provide deposit accounts and (usually) pay a reasonable rate of return to depositors.  Banks are ‘safe.’  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 the corner and discovered the petrol station that had reduced petrol prices to below £1 a litre?  How soon we forget that the price was 65 pence a litre and that the government is taking a huge ‘turn’ on our money.  We got used to paying £1.12 per litre in a relatively short time span.

And now?  It is forecast to rise to over £1.30 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, should we be stating Fahrenheit or should the temperature for the forecast be in Centigrade?

The broadcasters raised an interesting point: the weatherman said, that whether the temperature was given in º F or º C only mattered at the extremes. In other words, when it was very cold, minus two

(-2ºC) Centigrade was more relevant to our psyche (how we understand numbers and relate them to reality) than twenty seven degrees Fahrenheit (27ºF). 

On the other hand twenty two degrees centigrade (22ºC) did not relate to how warm it was when compared to seventy two degrees Fahrenheit (72ºF).  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 ‘cor blimey’ 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 ‘certainty’ 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 ‘timing’ 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 – 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 ‘giving forth’ on market cycles.  The classic market is primarily a relationship between property and equity price performance – 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 ‘floated’ 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 ‘capital’ 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 ‘seen you coming,’ 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 – 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 investor’s 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 ‘chase is on’ and the ‘bargains’ 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 ‘feel good factor’ 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 all that 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 ‘equity release’ 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 ‘real (perceived) value.’

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 banks’ 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 banks’ own balance sheets in the process (the banks’ solvency margins).

Banks lend money on the basis of a multiple of their ‘cash’ 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 ‘short sight.’  For every million pounds that property values sank the banks had to ‘claw back’ £11 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).  This was unlikely but possible. Was the FTSE 100 INDEX still something that people could put some trust in?  Let me explain:

In March 2003 and similarly in March 2009, the FTSE 100 index had ‘bottomed out’ at around 3250.  In chartist terms 3250 was a very firm base below which it would be very difficult for the index to fall.  That is the theory.  The theory does tend to hold up in practice. 

In October 2009 the index of 100 leading shares, the FTSE 100, was moving between 5200 and 5300 with every likelihood of it then moving ahead quite rapidly. 

But what of property?

Commercial property reduced in value by half.  Could it halve again? The great thing about property is that at the bottom of its market, it becomes moribund, it plateaus out. The graphic representation shows that property values become very flat, uninteresting, and a ‘safe’ but poor value as an investment, for a protracted period of time. 

A great number of people lose extraordinary amounts of capital through the effects of negative equity, the forced sale of ‘buy to let’ properties of being caught in property funds that moved to a ‘penalty price’ so they were ‘locked into’ the investment for six or twelve months. Hence few people want to venture back into an inflexible environment. Once bitten twice shy.  The trust in property and the reliance upon the adage that; one cannot lose money in property, are all but lost to a significant market influence.

Description: Description: Description: Description: Description: Description: GRAPH

FIG 1.3 – property prices

This commercial property situation (a flat market) can last six to eight years, therefore the likelihood of a 50% further drop in value when that market is confirmed to be at the bottom, is almost non-existent.  The likelihood of any damaging reduction in the property index (REIT) over a five year period puts the prospect of a 7½% income per annum for five years, against the security of the European Property Index, firmly in the frame as a ‘buy’ signal.

As we go through this book I will expand on what I have tried to say in paraphrase in this opening Chapter.  Hopefully the graphics will help and, as we progress, the jargon will become more and more familiar; and more relevant to your particular savings or investment situation.  Please persevere, it is worth the effort.

The message that this book (Hindsight – The Foresight Saga) is conveying is that ‘timing is very important’.  Yes one can take a twenty, thirty, or forty  year view and be invested for that length of time and allow invested capital to move up and down with the markets. That is okay, indeed it is a fundamental of how you should work your long term aspirations to build up funds in order to pay off a house purchase, create an income in retirement, and so on. 

The short term view has to concentrate on where the markets are in relationship to where they are expected to go, and be ‘of the moment.’ The timing of entry into an investment optimises the return.

However, I shall illustrate that ‘optimising returns’ depends largely on what is happening with the property market and the equity market specifically. It is their inter relationship with each other over a twelve to fifteen year time span, that is really important in providing you with guidance and the markets with vitality.

Whether you are in a ‘capital’ orientated market; where people are running for growth and a quick return, or in the ‘income’ phase, where quite the opposite dynamic is in play; consolidation, comfort and a reasonable return with a medium to long term view, has to be decided – and adhered to - at the point where an investment or savings decision is made.  Your future depends upon it.

Hopefully I have whetted your appetite. Simplicity is difficult, but I will endeavour