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Friday, November 5, 2010
A $100 MILLION CHALLENGE TO GMO’S JEREMY GRANTHAM
Mr Grantham has triggered a tsunami of global media attention by alleging that the Australian housing market is a “time bomb” and overvalued by 42 per cent on the basis of his belief that Australian dwelling prices are “7.5 times family income”. To quote one News Limited report:
“[Mr Grantham] said yesterday Australia had an unmistakable housing bubble and that prices would need to come down by 42 per cent to return to the long-term trend. "You cannot possibly miss it," he said. "The price of housing typically trades about 3.5 times of family income and in bubble it goes to 6 or …7.5 (times). "Australia is having one now. You are at near 7.5 times family income…which suggests you are twice the size that you should be." In Australia's case, Mr Grantham described the housing market as a "time bomb" just waiting for interest rates to increase and become impossible to support…If the Australian housing market did not return to the normal multiple of family income, he said "it will be the first time in history." "Sooner or later, the rates will go up and the game is over."”
In response, Rismark has dispassionately presented the hard empirical data that shows Mr Grantham got his maths wrong. Australia’s dwelling price-to-income ratio is not 7.5 times, as Mr Grantham would have us believe. Based on the best available measures, it is just 4.6 times as at June 2010 (and likely to decline in the third quarter). Furthermore, this 4.6 times estimate has been independently verified by the Reserve Bank of Australia, Goldman Sachs, Westpac, CBA, ANZ, HSBC and other third-parties.
The Deputy Governor of the Reserve Bank has also dismissed Grantham’s claims, commenting, “People feel that house prices in Australia are quite high…But, if you look across the whole country, the ratio of house prices to income is not that different from most other countries.”
Nonetheless, Mr Grantham is in good company. The Economist newspaper concluded in October this year that the Australian housing market was the most overvalued—by 62.3 per cent—of the 20 countries they track. Morgan Stanley’s Gerard Minack is another comrade-in-arms, arguing that “Australia’s debt-fuelled housing market remains a major macro risk” with house prices around “40% above fair value.”
So we would ask Mr Grantham to cease and desist from the hyperbolic jawboning. GMO currently manage USD$104 billion (slightly less in AUD terms). If you have conviction regarding your predictions about the “time-bomb” that is Australia’s $3.5 trillion housing market, we would ask that you put your money where you mouth is.
This is the deal. Rismark believes it can likely facilitate a transaction whereby Mr Grantham will be able to invest $100 million into a short position over the RP Data-Rismark Australian capital cities dwelling price index, which is universally regarded as the most accurate and timely house price benchmark in the market.
Following a torrent a criticism, Mr Grantham appears to have placed tentative conditions on his extraordinary assertions, opining that, “In Australia’s case, the timing and speed of the decline is very uncertain, but the outcome is inevitable.”
Recognising Mr Grantham’s equivocality, we will give him lots of time—three years, in fact. That is, he would be able to invest his $100 million for a three year horizon against RP Data-Rismark’s Australian capital cities dwelling price index.
Mr Grantham’s investment would be structured as a very simple “delta-one” transaction: for every 1 per cent fall in the index, Mr Grantham would receive $1 million. Conversely, for every 1 per cent rise in the index, Mr Grantham would pay $1 million away. The trade would be settled at the end of three years with monthly margining to manage credit risk.
To be clear, Rismark would need to work pro-actively with Mr Grantham to construct this transaction. 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 Mr 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.
We eagerly await Mr Grantham’s response, and can be contacted at email@example.com
Further background material:
Rismark’s housing forecasts have been consistently accurate. In contrast to The Economist, and other doomsayers, Rismark correctly anticipated the very modest 3-4 per cent peak-to-trough downturn that the Australian market experienced in 2008. In 2009 we projected that the market would surprise on the upside with the strength of its recovery, as it did. And since the start of 2010, we have been forecasting that the market would stop growing in the second half of the year, which is what has transpired.
Looking ahead, we are relatively bearish over the next circa 12 months on capital growth, and think that if the RBA does raise the target cash rate in line with the consensus economist estimate of 5.5 per cent, Australian dwelling prices will be placed under modest downward pressure. We recently disclosed analysis that showed that on the five previous occasions that the RBA had aggressively lifted interest rates since 1993, dwelling prices had fallen. Rismark does not expect this time to be any different. Through the cycle, however, we believe that dwelling prices will broadly grow in line with disposable household incomes, as they have done in the past. Total returns, including net returns, should be higher again.