Australian (and New Zealand) housing market has been on an absolute tear for the past couple of years.
We believe this frenzy won’t go on for much longer. In fact, 1 in 5 Australians are already struggling to pay their mortgage.
So today, we look at a couple of ways to position for the burst of Australian housing bubble by expressing a bearish view on Australian banks, which have outperformed the global banking sector for 25 years.
A long-short trade – long US listed iShares Global Financials ETF (IXG) and short Westpac Banking Corporation (WBK) against it for a “market neutral” pair trade.
At least 5 years but probably closer to 10.
Hard to say with any “precision” but it wouldn’t surprise us to see the global banks outperform Aussie banks by a magnitude of 4:1 over the next 10 years. And that is merely assuming that Aussie banks retrace just half the gains they made relative to the global banking sector. Markets tend to overshoot on either side and so we wouldn’t be surprised if years, hence we look back and realise that this suggestion proves to be conservative.
Euphoria, otherwise known as panic buying, is one of the tell tale signs of any bubble. When it comes to real estate in Australia and New Zealand you really have got to see the “euphoric” behavior to believe it. Every day yet another crowd appears outside a house in Sydney, Melbourne, or Auckland. The event? A bloody auction.
“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.” — Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
Buyers are in a frenzy for fear of being left behind, something that you’ll be familiar with if you’ve studied even a modicum of financial history. Remember technology stocks in 1999/2000 and the housing bubble in North America which burst in late 2007?
It’s not different this time. This behavior in itself should be a dead giveaway that something is terribly terribly wrong here.
“Bull markets die in euphoria.” — John B Templeton
I have been debating how to start this Trade Alert, In fact, I have started twice before this, torn up the digital copy, grumbled at my dog, and in doing so getting more irritated with myself for wasting time. So I stood back and asked myself, “what do I have to offer here”?
From the perspective of a “fundamental” analysis of the Aussie and New Zealand property market there isn’t much I can add to the discussion that hasn’t already been discussed in elaborate and detailed ways by myself and others before. So I’m not going to spend too much time on building an argument on why I am “bearish” the Aussie (and NZ) property sectors but rather dedicate a fair amount of this alert towards various ways how to “intelligently” apply a bearish view.
You see, from my (hard earned) experience many will often have a view, sometimes the exact correct view, and yet fail to adequately participate and will sometimes even lose money. The application of your view is just as important as the view itself. There is no “story” with the application which is perhaps why so few dedicate time to it but I know of exactly zero successful fund managers and friends who don’t do just this.
In many ways what is going on “down under” now is an echo of what happened in Ireland, Portugal, Spain, etc. 10 years ago.
1 in 5 Aussies are now in trouble.
This, folks, is more fragile than a sleep deprived, hungry, menopausal mother coming home to burnt dinner, a blackout, and her husband in bed with the neighbor.
So what happens when rates start to rise?
In fact, the argument can quite easily be made that rates need not rise for this to go from peachy to “oh, dear mother of Mary”. Inflation pressures eating into consumers earnings can easily do it. Any exogenous global event causing swap rates to blow out, which would cause Australian banks funding lines to both ratchet lower on volume and cause these banks to pass on the higher borrowing costs to consumers. When you’re this highly leveraged, there are any number of pins lurking around the balloon park.
This is just “God damn” scary:
Likely this is what freaked out one of Sydney’s better known fund managers. A few months ago he closed up shop, giving all clients back all of their money – all $2bn.
And put your laughing gear around this:
And the valuation of Aussie banks? Well, take a look at the weighting of Aussie banks relative to other countries in the Dow Jones Global Titans Bank Index (the top 30 banks in the world by market cap):
Now, a below average middle schooler who’s found the wonders of pot could tell you there is a problem here – how do Aussie banks have a bigger weighting than the UK, France, and Japan? For reference, Japan has a population of 130 million people while Australia has 24 million. Something is seriously out of whack here!
Applying a Bearish View
So how do we play this? The currencies of both Australia and New Zealand? Aussie bonds? While I think both will likely come under pressure I don’t think this is the best way to play this.
I think there is a much easier way to play this bubble and that is via the equity market, specifically via Australian banks.
Why Aussie banks and not the general market? In short, the Aussie stock market has become one ginormous bank. Some 45% of the market cap of the Aussie stock market (via the The iShares MSCI Australia ETF) is accounted for by financials (below). Imagine that!
If we take the world stock market (as per iShares S&P Global 100 Index), financials represent about 16%.
I will be the first to admit that I don’t know what the “ideal” or “fair value” weighting of financials should be. However, I am 100% convinced that 44% of a resourced based/developed economy’s stock market is way too high.
From a “crowded trade” perspective think about this: no pension or mutual fund in Australia would dare not have an “overweight” exposure to the big Aussie banks. I know because I’ve spoken with many of them. However, ask yourself who would consider having an “overweight” exposure to Bank of America, UBS, HSBC, Citi, or Mitsubishi bank?
Suffice to say there is a huge pool of marginal sellers in Aussie banks, built up over years of prosperity with high and stable dividends. At the same time, I doubt there is a big pool of marginal sellers in the likes of UBS, Citi, or Mitsubishi.
Take a look at the performance of the the All Ordinaries (Australian general equity index) relative to Commonwealth Bank (CBA) and Westpac (WBC) since the early 1990s (that is about 25 years). The All Ordinaries has underperformed Australia’s two big banks. This coincides with the “unbridled” growth in the Aussie and NZ property market.
Is there enough evidence from a technical perspective to suggest that the All Ordinaries is now outperforming banks? Yes, but be careful because I could have also said that in 2006 and 2007. Things are rarely that clear cut or easy!
After 25 years of outperforming the general equity market and after 25 years of property prices doing nothing but go up (to astronomical levels) coinciding with levels of personal debt that would make Donald Trump blush I wouldn’t be betting that Aussie banks will keep doing so. If you subscribe to the concept of “mean reversion”, the opposite is most likely to occur and the magnitude of the reversion is likely to overcompensate… meaning that Australia’s banks are more likely to go beyond a standard mean reversion.
Now, here is where things get really interesting: check out the performance of Dow Jones Global Titans Bank Index relative to Westpac. Ever since 1990 it has underperformed, but that now appears to be coming to an and end. This chart looks perfect in terms of a long term bottom:
Now take a look at the relative performance of the global banking sector and Westpac. Once again, I’m merely using Westpac as a proxy for Aussie banks.
I first recall hearing about people crowding at auctions in Sydney in about 2012/13, and this coincided with the absolute bottom in the chart below (the peak of Aussie banks relative to the global banking sector):
There is a deluge of other info, graphs, articles, etc. which I could bring to the table to argue the case that Aussie banks are in deep trouble. However, from what I have presented above I think I have done enough and, as mentioned, I wanted to dig into the “how” in this alert.
How to Apply a Bearish View on Aussie Banks?
First of all, let’s establish the time frame. I’m looking at 5 to 10 years from now. I want to give myself as much time as possible because the human reaction to these things is always that we believe it will happen tomorrow, and there is a risk to finding data points that validate one’s thesis. Confirmation bias is what it’s called, and one method of eliminating some of this risk is to develop strategies which provide you with additional time.
I’m not interested where a market will be 6 months, a year, or even 2 years from now – these are short term movements. In situations like these the markets can turn quickly and viciously but, and this is important… they can flop along for longer than we ever thought possible… until suddenly they don’t.
Fundamentals can take a long time to play out. I believe 5 years should be plenty of time. But I am also aware that what overshoots on the upside tends to overshoot on the downside. So this is why I get the feeling that Aussie banks are set to seriously underperform for a very long period of time.
Which Aussie bank to get bearish on? Frankly, the whole lot! What’s likely to happen is that the entire banking sector goes down materially. I’m not going to get caught up in which Aussie bank underperforms. It is semantics and misses the bigger question. I will refer to Westpac mostly because it is just a proxy for the Banking Index in general (it is the second biggest Aussie bank).
Where does New Zealand fit into all this? I’m glad you asked. All the big banks in New Zealand are either Australian banks or owned by the Aussie banks, so for our purposes New Zealand is just an offshore island of Australia.
So to apply a bearish view on Aussie banks we can do it via an absolute perspective – i.e position for Aussie banks to decline in value 5 years from now – or from a relative perspective (e.g. where Westpac will be trading relative to JPMorgan or HSBC).
From an absolute perspective we can “simply” short Westpac. Now, I’ll let you in on my thoughts because I was bearish on Aussie housing market and banks as a result way back in early 2014. For a host of reasonsm I never got involved then but let’s take a look at what would have happened had I taken a position. What if I had shorted WBC then when it was at 32. Where would my stop have gone? Probably 10% higher at about 35. Well, it got there and went a whole lot higher to 40. It then proceeded to get smashed and is now back at about 30. On getting stopped out: where would I have gotten back in again?
Also, at what level should I have been looking at to get out of the short trade assuming it went my way?
When shorting don’t forget that you will have to pay out the dividend which at the moment is about 6% p.a. That’s a pretty hefty yield. So If I did go short at the start of January 2014, then I would be down about 20% just on the dividend. Ouch! Of course, the dividends may change over the coming months particularly if a whole lot of real estate loans/mortgages go sour, but we can’t be 100% sure of timing and this means we have to factor in this as a business cost and as business costs go… this one is pretty steep.
Shorting from an absolute perspective is tough work (been there, done that). Some of you are adept traders and will favour direct shorts. That’s fine. I’m presenting a number of ways here so please choose the most appropriate for you.
Ok, let’s move on.
What about a put option on Westpac? You can get puts going out 3 years but they aren’t that liquid. At this stage, December 2019 puts are available and an 30 strike put will cost about 4.5.
This means that CBA would have to fall 9 points to 21 (a 30% fall) come December 2019 for you to make a 100% return on the premium in the option. This isn’t unreasonable. Of course, if I did decide to buy puts at the start of 2014, they would have been December 2016 expiry, and they would have expired worthless.
Never mind the great things about puts is that you can risk a small amount, position sizing intelligently, and be able to go again. Naturally, if I did go again, then rather than making a 100% return come December 2019 if WBC was to fall 30%, I would just be breaking even on my trade. Clearly timing is a real issue.
Three years may seem like a long time but more often than not it is not long enough. Markets, like teenagers, can remain irrational for longer periods than we can comprehend!
Our job here is to intelligently position for inevitable consequences (key word being intelligently). This means that we need to be cognisant of time erosion and the fact that markets can stay irrational for a long time.
I’m not trying to paint a nasty picture of why one shouldn’t go there with respect to shorting WBC (Aussie Banks) or buying puts on them. Rather, I’m being realistic. There is nothing worse than someone who paints a delusional picture on a trade promising all sorts of spectacular returns assuring you of little risk. That works for marketers pumping newsletters but it’s not going to work for us managing our capital.
Shorting Aussie banks from a relative perspective. Let’s look at shorting Aussie banks relative to another stock or market. This is where I see the most opportunity. This seems to me like a dead certain outcome. What is perplexing is against which bank(s) will I get the biggest payoff. I have my ideas on this but more on that later.
The great thing about trading from a relative perspective is that you don’t have to worry about “where the Dow is heading next?” – something every man and his dog seem obsessed with. Just so long as the stock you are long of goes up by more or down by less than the stock you are short of you make money!
Base Case Trade
Long the iShares Global Financials ETF (IXG) and short Westpac’s US listed ADR (WBK).
What are we trying to capture here?
The “mean reversion” of the valuation of Aussie banks (using Westpac as a proxy) relative to world banks. I’m not saying that European or Japanese banks offer better value than US banks etc. I’m merely betting that Aussie banks are grossly overvalued to their global counterparts.
Why the the iShares Global Financials ETF (IXG)? It is the best global banking ETF that is available. As a matter of interest, here is the top 10 holdings of the the iShares Global Financials ETF:
And the Westpac’s ADR? Westpac is the only Aussie stock with an actively traded ADR on the NYSE (the others have ADRs but these trade via the illiquid Pink sheet market). It isn’t necessary that one shorts the Westpac’s ADR. One could short Westpac on the ASX (or CBA, if you choose).
However, what is important in a long/short trade is that the dollar amount on the long side is equally offset by the dollars on the short side. So if one were to buy US$10,000 worth of the the iShares Global Financials ETF, then one needs to short US$10,000 worth of Westpac. So that would be US$10,000 worth of the Westpac ADR or AU$13,333 worth of Westpac on the ASX (assuming the AUDUSD exchange rate is 0.75). The Westpac ADR just makes things easier because it is already trading in USDs.
In essence, we would be long the chart below:
You may be wondering why I mix and match different indices. The answer is that many indices upon which ETFs are based don’t go that far back, at least on Reuters.
For example the S&P Global 1200 Financial Index (on which the iShares Global Financials ETF is based) only goes back to 2001. So as a proxy for that I use the Dow Jones Global Titans Bank Index, which goes way back to the early 1990. So the chart you see above is more or less a microcosm of the chart below:
I’m not a pure chartist, my assessment of fundamentals makes up a significant part of my analysis. However, every now and then you come across a chart like this one above where you just know with “99% certainty” that this is the start of a multi-year trend. It is setups like these that get me really excited.
The Mechanics of the Long/Short Trade
Let’s say we were real geniuses and 5 years ago we went long $10,000 of the iShares Global Financials ETF and short $10,000 of Westpac’s ADR when the ratio of IXG to WBK was 1.82. The ratio is now 2.76. Yes, we have made money – some 60% but I will get to that later.
Before you get all carried away on what a great trade this was (and I am convinced still is) just understand that 3 years after we placed this trade we were still more or less unchanged – the ratio was still about 1.82 (just above to be precise). As I said before, more often than not “genius” ideas take way longer to play out than you think.
Below I indexed the iShares Global Financials ETF and Westpac’s ADR to 0 in June 2012. The iShares Global Financials ETF is now up 71.5% (so the $10,000 you were long of is now $17,150) and Westpac’s ADR is up 13.2% (and the short has gone from $10,000 to $11,320).
So how much would we have made? We made $7,150 on the long side and lost $1,320 on the short side so net-net we are up $5,830.
But what is the percentage return? Well, this is where things get a little subjective and “hairy”. If we just had $10,000 in our account to start with, then this would be a 58% return.
Now, the leverage guys out there will be yelling at me saying “but Chris, what if we only had $5,000 in the account and still went long $10,000 and short $10,000?” Then this would be a 116% return! Wonderful, but not so quick. If you look at the charts above you will quickly realize that this trade didn’t initially go our way. Rather quite the opposite.
Below is the graph above but just for 2012 and 2013. Note that Westpac was up 70% from June 2012 to May 2013 and the iShares Global Financials ETF was up “only” 40%. So the $10,000 we were long of went to $14,000 and the $10,000 we were short of went to $17,000 (a net loss of $3,000). So if you had financed this trade with $5,000, then you would have been down to $2,000 and probably already in margin call (or pretty damn close to it).
Truth be told, I didn’t do this trade but clearly wish I had. The point of walking you through this trade and detailing the outright short method as well as the outright puts is to highlight the “highs and lows” of the trade. I want you to get an understanding of how to manage risk. I’ve learned the hard way over the years, and I’d dearly love it if you don’t have to.
Yes, the payoff is great now, but it took a lot longer than I would have envisaged to play out. And the volatility is always something that surprises you. In short, it isn’t easy.
Upside Expected on the Trade From Here on?
I think this is just the start of a 10 year trend where Aussie banks underperform their global counterparts so goodness knows how much upside is on offer. From a shorter-term time horizon, if the ratio of IXG relative to WBK gets back to where it was in 2006 (pre-GFC), then it would equate to IXG outperforming WBK by about 60%. And still, that is just the start because remember, Australian and Kiwi housing markets have been on a tear before 2006 where they literally paused and then just continued higher.
It is scary to think that if the global banking sector retraced half of its underperformance relative to Westpac over the last 25 years, then we would be staring at a 4:1 payoff but that’s what it is. If we get a full blown meltdown then it could easily be much higher.
Administrative and Management Considerations
There are some minor complications in the execution and admin of this trade. There will be a stock lending fee for shorting WBK (this charge is broker dependent).
You will also have to understand that any dividend paid by WBK will have to be returned. So if the dividend yield on IXG was 3% and on WBK 6%, then there will be a “negative carry” on the trade by 3% p.a. This won’t detract from the attractiveness of the trade but merely takes away a bit of the icing on the top. That said, if you’re shorting directly, as I pointed out earlier, you would be paying the 6% without receiving the 3% to net against.
Now, what happens in the situation above: IXG is now valued at about $17,000 and WBK at about $13,000 – it is no longer dollar for dollar neutral. You can either sell down IXG so it equals or sell more WBK for the short value to become $17,000. I wouldn’t recommend rebalancing all the time (otherwise you are just trading market noise) but rather wait until values deviate by about 30% before rebalancing.
But what if the opposite was to occur? For example, if the short dollar amount was to exceed the long dollar amount by 30%. Obviously the position is going against you. There has to be a stop loss strategy. My thoughts would be to buy back enough of your short position so that it equals the dollar amount of your long position.
On the face of it these long short trades may look very simple but when you dig deeper there are lots of little complications which I want you to be aware of in order to make the trade work properly.
For some of you (professionals) this will be old hat and for others entirely new. Let’s explore this trade in a little more detail…
For those of you who are happy with being long IXG and short WBK and don’t want to complicate your life any further (wise choice), then you can stop here.
However, for those of you who want to explore the possibility of a bigger payoff, then read on.
A More “Adventurous” Trade
To me the big question is: “which financial(s) should we be long of relative to Aussie financials?” To cut a long story a little shorter, is there more upside in European or Japanese banks relative to US banks? If so, then long a European and or Japanese bank ETF and short Aussie banks would be the better trade.
Now, this is a topic which I could easily add 50 pages to this Trade Alert, which I don’t want to do because so I want to keep things simple.
If I was going to take things a step further and instead of hedging a short position in Aussie banks with a broad world bank ETF (like IXG), then it would be Japanese banks. The valuation of Japanese banks is about half that of US banks (not that US banks were expensive in the first place) and about 30% less than European banks.
Now, if the performance of the global banking sector relative to Aussie banks blew your mind, then take a look at the performance of Japanese banks relative to Aussie banks (again, using Westpac as a proxy):
An ultra long-term bottom is being hammered out. But here is something very interesting – for all the “tough/challenging” times that Japanese banks have had since 2009 and the great times that Aussie banks have had on the back of a real estate and commodity boom, Japanese banks have performed exactly in line with Aussie banks during that time.
One wonders what would happen if conditions “get tight” for Aussie banks and start “improving” for Japanese banks? This could get explosive real fast.
How to play this? There is an ETF in Japan that tracks banks – Nomura’s TOPIX Banks Exchange Traded Fund (1615). Below is the weightings within the ETF:
Alternatively, you could just do a long short trade on Mitsubishi Bank’s ADR (MTU) and Westpac’s ADR (WBK). With Mitsubishi Bank accounting for about 30% of the Index any position in Mitsubishi will by default give you exposure to the Japanese banking index.
How much upside could one expect? Well, if the ratio of MTU to WBK was to get back to 2007 levels, it would equate to MTU doubling relative to WBK – and that is just the start of it.
Reviewing the Trade
- Long IXG and short WBK in equal dollar amounts.
- Finance the trade with 2:1 gearing. For example, if you go long $10,000 and short $10,000, hold $10,000 against this position.
- If the long dollar amount exceeds the short dollar amount by 30% or more, sell more of the short dollar amount to equal the long dollar amount.
- If the short dollar amount exceeds the long dollar amount by more than 30%, buy back enough of the short so that it equals the long dollar amount.
- Time frame – this is at least a 5-year view and probably a lot longer.
- Allocation to risk: 5% of risk capital. So if you had a $100,000 portfolio, then you would be long $5,000, short $5,000, and financed with $5,000.
I believe that this is one of those trades where probabilities are really heavily weighted on our side, and with a correctly structured and managed trade we can neither be a victim of time nor volatility – the two killers for any money manager.
Best of luck.
Founder and Editor In Chief, Capitalist Exploits Independent Investment Research
Founder and Managing Partner, Asymmetric Opportunities Fund