Prior to the Great Recession some asset prices were at all time high price levels. That in itself does not cause problems, but there were some fundamental issues that made some of these asset valuation levels unsustainable. For example, higher valuation of real estate is not necessarily a problem as long as the valuations are based on solid fundamentals.
We have seen places like New York, Tokyo and London exhibit real estate valuations that are far beyond the average person’s affordability. However, in these markets it can generally be sustainable due to the fundamentals of supply and demand. The essential fundamental factor is that each of these cities has populations of over eight million people with even larger surrounding area populations that need and want to work within the city for better paying jobs. Due to that kind of demand, the city valuations can maintain higher levels than seen in other urban markets. Thus during periods like the real estate bust between 2007 and 2009, prices in New York City, as measured by the S&P Case-Shiller Single Family Home Index, only declined 20 per cent because there was still a reasonable amount of support.
The problem was that from 2001 to 2006 cities like Tampa, Miami, San Diego, Los Angeles, Las Vegas and Phoenix appreciated more than 80 per cent. Cities like San Diego, California had maintained consistently high appreciation rates since the late 1990s which did not cause issue. The problem stemmed from the way these housing markets increased in value like in Las Vegas. The value increased by predatory loan practices, speculators who purchased multiple properties, and unqualified overleveraged people that could not service these loans realistically over the long term. This perfect storm of lenders and borrowers cause dramatic damage to the housing market in many US cities and much collateral damage to the economy. This lack of fundamental support was reflected in cities such as Las Vegas where, according to the S&P Case-Shiller Single Family Home Index, prices declined by over 55 per cent from 2007 to 2009.
What makes analysing the real estate boom and bust cycle so interesting is how some of these fundamentals can be applied to the reinflation of the global economy. Specifically, there has been much talk of whether the recent increase in equity asset prices, since the low of March of 2009, are sustainable or unsustainable. If the equity markets have a setback, would it be more like the case of New York City property valuations, where there is solid support, which would result in a mild decline in asset prices or more like Las Vegas where it is build on shaky financial practices which could lead to a market free fall.
With all the central banks taking action to help stimulate the economy, the equity markets have seen a dramatic increase. Since the five year low in the S&P 500 Index on 9 March, 2009, to 31 May, 2013, the index has had a price appreciation of approximately 141 per cent. That kind of increase in value would make any sane investor re-examine their position and question whether they wanted to just take profit and sit on the sidelines to see what will happen next.
However, if you look at the increase in the market from 5 October, 2007, before the great decline, the price appreciation of the index is only 5.97 per cent. If you review the S&P over the past 15 years from 31 August, 2000, to 31 May, 2013, the total price appreciation over this time period was only 7.45 per cent which by historical standards is pretty low.
To answer the question of whether there is a pull-back in the market, and what it would look like, it is best to refer to supporting economic data as well as the fundamental market data. Per Bloomberg consensus of forecasted growth, the world GDP growth is expected to be 2.18 per cent in 2013, 3.05 per cent in 2014 and 3.26 per cent in 2015. Also, unemployment is expected to drastically decline in the US in 2015 to 6.55 per cent. These would be very supportive factors for growth of the global economy.
In reviewing the price/earnings ratio for the S&P 500 as of 14 June, 2013, some of the lower estimates for the forward price to earnings ratios are expected to be approximately 15.1 for 2013 and 14 for 2014. At the same time, lower estimated projected earnings growth rates are 4.5 per cent in 2013 and 8.3 per cent in 2014. On a historical basis this is getting a bit towards the higher end of the middle value range but not necessarily overvalued.
With the exception of a calamitous event such as the US sub-prime mortgage crisis, the Asian financial crisis or the European debt crisis, any pull-back in the market would be expected to be more of the lighter variety of a market correction of 5 to 20 per cent as opposed to a market free fall.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.