Why a Housing Index Won’t Work…

That’s today’s headline. The headline for Monday’s Money Morning will be the follow on… “How a Housing Index Could Work”.

Yesterday I mentioned that the Australian Securities Exchange (ASX) is considering offering an index based on residential house prices.

The index – from what we can gather – will allow investors to bet, gamble or punt on the direction of the residential housing market.

In a moment I’ll begin to explain why this could be either a completely meaningless index, or why it could be really quite useful… depending on how it’s structured.

But first, I want to invite you inside the mind of a Keynesian economist. Don’t worry, I know it’s scary, but I’m here with you.

In all seriousness, we do wonder what planet Keynesian economists come from. Planet Keynes perhaps?

Last week we wrote to you about the bizarre mentality of the mainstream economists. How they fear the unemployment rate going too low because of the impact on inflation.

Apparently the mainstream economists consider full employment to be based on an arbitrary number. Somewhere around 5%. Once it reaches that point then that’s enough. No more employment please.

Even if there are people still unemployed who would like work.

Naturally enough when yesterday’s unemployment numbers were released by the Australian Bureau of Statistics (ABS) Comsec’s Craig James was eager to see a silver lining in the increased unemployment rate:

“Secretly the Reserve Bank wouldn’t be disappointed that the jobless rate has troughed for the time being.”

Wouldn’t want more people getting a job would we? Of course that’s easy to say when you’re a mainstream economist at a big comfy bank. Much better to keep that 5.3% of unemployed on welfare payments and have the taxpayer fund them rather than having someone in work and being able to fend for themselves.

But Mr. James also says, “It’s important not to over-react to one month’s set of figures”… but then that’s exactly what he does.

He goes on:

“Effectively the Reserve Bank lifted rates too far, too fast, robbing the economy of momentum at a time when the US and Europe continued to meander along…

“However it does mean that the last remaining rationale for a rate hike in 2010 has been taken away. The risks are now skewed to the Reserve Bank remaining on the interest rate sidelines until 2011…

“The Reserve Bank is solidly on the interest rate sidelines. There is nothing that could prompt the Reserve Bank to lift rates, in fact the policy leaning is now shifting – ever so slightly – in favour of rate cuts.”

Yet it was only two weeks ago on August 3rd that Mr. James wrote:

“Reserve Bank policymakers could indulge in some well deserved boasting. The Australian economy avoided recession, growth is ‘near normal’, emergency rate settings have been removed and inflation is back in the target band…

“While CommSec believes that it is more likely that rates will rise rather than fall in the future, the next move could very be in 2011 if the mixed domestic and global readings persist… We are pencilling in a 25 basis point rate hike late in 2010…”

And of course he finished off with, “property is still fundamentally attractive…”

It’s important to get at least one spruik of the property market in!

Now, the reason I’ve shown you these comments is not to play a game of Harry Hindsight, but rather to show you how 99% of mainstream economists – and Craig James is as mainstream as they come – have no clue about how an economy works.

That’s why they are unable to provide a consistent and logical message. It’s why their opinion flim-flams and flip-flops from one week to the next.

One week they’re praising the RBA for the great work it’s doing in manipulating interest rates, the next week they’re accusing the RBA of getting it wrong because the unemployment rate has moved higher.

You’d think they would have figured out by now that it isn’t possible to micro-manage an economy.

You can’t pull levers and push buttons in order to accurately predict and influence the actions of 22 million people. But still they carry on with their futile little game.

But anyway, we’ve strayed well off course here. Back to the housing index that the ASX is apparently looking at.

First off we’ll say that the ASX has a terrible record in the area of new product development. If it’s dealing in shares then it’s fine. It may not be perfect, but it seems to do a relatively decent job.

When it comes to the exchange traded options market, well, we’d give it no more than a C grade. It does its job, but once you get outside the top twenty or so stocks, the liquidity on the options market is pretty slim. But that’s not entirely the ASXs fault, hence why it still gets a C grade.

As for Index futures (SPI) on the S&P/ASX 200 it seems to do a decent enough job there as well. There’s plenty of liquidity and we dare say most futures traders are probably happy with what they get.

But anything outside of that, the ASX is hopeless.

Take a look at the trading volume for anything outside the major bond and index futures. There’s nothing traded. You can see for yourself here.

Then there’s the ASX listed contracts for difference (CFD) market that was marketed in a blaze of glory about three years ago but which has never risen above the level of also-ran.

The ASX thought it could get in on the CFD craze and make a killing, winning back some of the trading revenue it had lost to the over the counter (OTC) CFD providers. But they haven’t and it’s been a flop.

At some point the ASX will give up and ASX CFDs will likely go the same way as the International trading service the ASX quietly closed down about four years ago.

You probably don’t even remember it, it was so unmemorable. We think – from memory – it was called Trade Link, or something like that. The idea was that you could buy shares in international companies such as Microsoft and IBM through an Australian broker.

An added benefit was that the trades would be settled in Australian dollars and would appear on your CHESS holding statement so that you wouldn’t have to fuss around with foreign exchange, separate accounts, and all sorts of other nonsense.

To be fair, it was a nice idea, but as is usually the case when a monopoly organisation tries to innovate, the service went nowhere. Brokers weren’t interested, nor were their clients and so the ASX closed it down.

Now they’re looking at operating a housing index.

Our first bet is that it’ll never happen. We could be wrong of course, but that’s just our take on it.

Our second bet is that even if it does get off the ground it’ll be a complete waste of time. The ASX makes it’s money from the stock market. From people trading shares.

Anything outside of that, forget it.

Think about it, most of the trading volume on the ASX goes into trading the top fifty stocks on the market. Why? There are many reasons, but mostly because they’re the most well known and biggest companies. It’s only natural that most investors would tuck into those stocks.

But it’s also the impact of the funds’ management industry too and their desire not to underperform their peers. Therefore they will all tend to hold similar portfolios.

In that case, what are the odds of big and small investors having any interest in a property index?

That’s where it comes down to how the index is measured. Done right and there could be a lot of interest. Only ‘could’ mind you.

Share indices for instance are based on the value of shares that comprise the index – no points for getting that right. It’s pretty simple and reasonably transparent. You know that the biggest companies in the index will have the biggest impact on the performance of the index.

In other words, not only can investors see the price action of the index but they can see the price action of the stocks that comprise the index.

Of course there’s already one property index on the ASX. It’s the SPDR S&P/ASX 200 Listed Property Fund [ASX: SLF]. Subscribers to Australian Small-Cap Investigator will recall we tipped that index as a buy recommendation early last year, right near the depths of the market downturn:

We tipped it at $6.41 in March 2009 and then sold at $8.00 in November 2009 for a 24.8% return.

As it happens it was nowhere near as big a return as we had banked on. Unless there’s the prospect of a triple-digit percentage gain we don’t even consider tipping a stock.

However, we saw it as the ultimate contrarian play. Buying into the property market right at the point where property bulls and bears – including your editor – were most bearish (until now) on the housing market.

Of course, that particular index is an index of commercial property trusts, so it can’t be directly compared to the housing market.

But take another look at the chart above. This time the volume bars. Each bar represents the volume traded during one week. And this is where the problem lies for any potential housing index.

Even the most voluminous week – during March this year – there was still only two million shares traded. That works out as around $3.2 million worth of shares each day during that week.

Yet in recent weeks the volume has struggled to get even to $800,000 per day. Compare that to the blue-chips where already this morning ANZ Bank [ASX: ANZ] has traded more than $17 million worth, and it’s not even 11am!

So this particular index has low volume and quite frankly low interest among investors. But importantly, and in its favour, this index has component stocks. In other words you can check out which property trusts comprise the index.

You can choose to either invest in those components or in the index depending on whether you want to spread your risk or not. And just like a share index you can see the impact that the price movement of the underlying stocks has on the level of the index.

What I’m saying is that any housing index operated by the ASX must have the same level of transparency. Anything less than that and investors just won’t be interested.

If the index is just based on a theoretical price level of housing or a mathematical calculation of house prices, our guess is that it would become nothing more than an interesting novelty.

The question you’d need to ask is whether investors would trust punting big money on something that was a computer model driven rather than something based on the actual price and income stream from real houses? Some would, but we’ll guess the majority wouldn’t.

And that’s why we doubt the index will even get off the ground.

But there are two other points we do want to cover off. The main one being how a housing index could work. If done properly. It would involve residential rental properties as the underlying asset.

As far as we can see it shouldn’t be that difficult, and thinking about it, we’re rather surprised it hasn’t already been tried.

The other point we’ll cover is that the high price of housing could actually be a bar that prevents making an investable housing index a success.

But more on that on Monday…

Cheers.
Kris Sayce
For Money Morning Australia

Tagged as: economist, economy, house, housing, market, price, stock, unemployment