Hudson's Investment Methodology
The Economic Cycle
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The best way to learn about the workings of an economic cycle is to take a journey through a full cycle. We will begin this journey with the recession.
Historically, Australia has a recession every seven to nine years. The start of the recession is often characterised by high interest rates, growing unemployment, lack of consumer confidence and the failure of many businesses.
Fortunately, with gloom comes opportunity. Recessions force business to minimise wastage and improve efficiency and productivity.
Once the economy begins to improve (which it invariably does) companies quickly translate their productivity improvements into increased profits. Consequently, the share market begins to rise in value in line with improved company earnings.
This is the start of the share market cycle.
The Share Market Cycle
As a result of improved company performances, investors begin to regain confidence in the share market. This confidence accelerates the increase in the value of shares.
As the share market continues to rise, investors’ confidence in the market begins to outpace gains made due to good company performances. This is because of a number of factors, including increased investor savings, a buoyant economy and an overly optimistic view of the share market.
Eventually, the market reaches a point where the price paid for shares cannot be justified by asset backings or earnings. This forces a rapid reduction in the value of shares. This reduction is often known as a share market correction or, in extreme instances, share market crash.
A share market correction signals the start of the real estate cycle.
The Real Estate Cycle
As might be expected, share market corrections do little for investor confidence.
As the share market pitches restlessly, investors are quick to channel their savings into the security of bricks and mortar. Of course, a rapid increase in the demand for real estate results in a corresponding increase in property values.
Historically, the value of property rises by at least 25% per year throughout this period of the economic cycle.
Because property purchases are funded primarily by borrowings, a corresponding increase in demand for real estate causes an increased demand in borrowings (interest rates).
And because interest rates increase in line with the demand for real estate (as well as other factors such as inflation), the rapid growth of the real estate market cannot be sustained once interest rates make the cost of borrowing money too expensive.
However, unlike the share market, the property market stabilises at the close of the real estate cycle – rather than crashing.
This stabilisation in the value of real estate prices marks the beginning of the fixed interest (or cash) cycle.
The Fixed Interest Cycle
At this stage of the economic cycle, equity investment is not an exciting prospect for investors. The share market is doing little and interest rates are too high to make borrowing for a property an attractive investment.
Investors have little choice but to hold on to their current investments, or make the most of high interest rates and invest in debt (bonds, debentures and fixed interest).
High interest rates slow the economy and lead us towards another recession – the point where our journey began.
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