KEY POINTS:
Major changes in the perception of risk have made an important contribution to the recent downturns in equity and housing markets.
It is difficult to predict whether this alteration is permanent but, regardless, it is important for investors to understand the influence of risk on asset prices when
assessing investment opportunities.
The NZX's performance over the past 30 years is an excellent example of the relationship between risk perception and asset prices.
Residential housing has been transformed from a low- to a high-risk asset class and, as a consequence, is expected to be more volatile in the years ahead.
The NZX, with most other bourses, was boring during the second half of the 1970s. Investors were risk-averse after a prolonged economic slump and most major companies had price/earnings ratios (P/Es) of four or less.
The Government introduced tax incentives for fixed-interest securities that converted into shares in order to encourage equity investment.
These tax initiatives had limited success and by the end of 1982 investors were still risk-averse and share prices low. On Friday, December 3, 1982, when the NZX's benchmark index closed at 558, the historic and prospective P/Es of the 50 largest listed companies were just 4.7 and 5.2 respectively.
Six of the 50 companies - New Zealand Steel, Montana Wines, Independent Newspapers, Ivan Watkins-Dow, Skellerup Industries, ANZ Banking Group (New Zealand) and Rothmans - had prospective P/Es of 4.0 or less.
The market took off in 1983 with the arrival of Colin Reynolds, Allan Hawkins, Craig Heatley and other young entrepreneurs on the stage. Share prices rose and P/Es expanded, particularly when based on operational earnings, as investors began to believe that share prices could only rise.
When the benchmark index peaked at 3969 in September 1987, a large percentage of investors, particularly those who had entered the market for the first time in the 1985-87 period, believed share prices would never fall.
A similar view has been held by many residential property investors in recent years.
The NZX made a slow recovery after the 1987 crash because most New Zealanders believed shares were too risky. The domestic market only recovered because of widespread interest by overseas investors, who owned just over 60 per cent of the New Zealand market, on a capitalisation basis, in 1997.
The perception that share prices can just as easily fall as rise is one of the main reasons why New Zealand investors have been quick to accept low-priced takeover offers.
Meanwhile there was a significant fall in the sense of investment risk in other countries, with most investors deciding capital markets are relatively riskless and they could buy assets without having to worry about the possibility of capital losses.
This view has been reinforced by central banks that have created a stable financial environment in the post-inflation era and have been quick to cut interest rates when capital markets weaken. Credit rating agencies, willing to give AAA ratings on low-quality products, contributed to this false sense of security too.
The widely held view that we were living in a low-risk environment had a positive impact on asset prices as P/Es expanded. At the same time residential property investors accepted negative annual cash flows in the belief that house prices will always rise.
The sub-prime crisis has clearly demonstrated that financial markets are not risk-free and sharemarkets are now experiencing two major downward adjustments, one reflecting concerns regarding earnings and the other a contraction in P/Es as investors reassess risk.
Rakon and Fletcher Building were two examples of this during the week.
Rakon was listed on the NZX in May 2006 after the issue of shares at $1.60 each. Its share price peaked at $5.67 on May 24 last year, just nine days after the company announced its result for March 2007. At its closing price that day the company had an historic P/E of 56, a prospective P/E of 34 and broker analysts had a buy recommendation on the stock.
This week's profit downgrade has demonstrated that the company is more risky than was perceived nine months ago. Broker analysts have maintained their buy recommendation but Rakon will have to over-deliver on its new forecasts if investor confidence in the company is to be restored in the near term.
Investors were not fully satisfied with Fletcher Building's profit announcement and analysts' briefing even though net earnings were in line with forecasts and the company reiterated its $450 million to $460 million guidance for the full June 2008 year. The dissatisfaction was because chief executive Jonathan Ling didn't spend enough time addressing the risk side of the investment equation.
Investors are concerned about Fletcher Building's 2009 year prospects, which Ling largely ignored. This omission contributed to the group's post-result share price fall because when overall confidence erodes and risk perceptions change companies need to address a wider range of issues than they do under more stable conditions.
It is difficult to forecast the length and depth of the sharemarket downturn but the longer it lasts the more the risk equation, through contracting P/Es, will weigh on share prices. Investor preference is also likely to shift from growth to value companies if the downturn lingers.
As far as the housing market is concerned, Real Estate Institute figures released on Wednesday revealed that the median nationwide house sale price was $340,000 last month compared with $175,000 in January 2002. This is a phenomenal increase when it is considered that there are almost no barriers to new home construction while it is extremely difficult to replicate a Rakon or a Fletcher Building.
House prices have risen strongly because most buyers believe prices cannot fall as the residential housing market is risk-free.
The first objective of a Blue Chip or any other housing salesperson is to convince potential investors that this is the case. Once investors have been persuaded that a market is risk-free they will buy almost anything. Blue Chip - which bombarded individuals with positive statistics - was successful in this regard as it managed to convince a large number of individuals to borrow against their existing homes and make deposits on developments, some of which hadn't even received resource consent.
The perception that prices cannot fall usually results in an unsustainable boom, particularly if a large number of new investors enter the market.
The willingness of investors to buy houses where the interest costs are greater than the rental income, even after taking into account the use of tax losses, indicates the widespread belief that prices could only rise.
The New Zealand residential housing market has been relatively risk-free, with the notable exception of the catastrophic 1885-1890 Auckland housing slump. But when investors adopt high-risk strategies, particularly 90 per cent or more gearing, then the market itself becomes high-risk.
If house prices continue to fall, and the perception of risk changes, then the residential property market could be in for a number of lean years.
House prices could decline to a level where rental income clearly exceeds interest payments and other property outgoings.
This indicates that residential property may be much more volatile in the years ahead than it has been in the more recent past.
* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management. bgaynor@milfordasset.com
