Wednesday, October 8, 2008

The Share Market Rollercoaster

The larger than expected interest rate cut of one whole percent has been welcomed as good news for struggling home-buyers. Even better is the expectation that there will be further cuts ahead, although not quite so dramatic. That’s the good news. The bad news is to be found in the reason the decision was made. While the earlier increases in rates were fueled by concerns about rising inflation, the decrease is motivated by the even bigger fear of recession. That’s where the outlook starts to become really scary.

The Reserve Bank has done the right thing, but that still may not be enough to prevent a serious downturn. Global conditions are such that it appears likely there will be a recession whether we like it or not. Almost anything that Australian authorities can do will be to cushion the blow, not to avoid it altogether. So where does that leave ordinary Australians?

With so much uncertainty still ahead, the sensible course is to reduce debt, reduce spending, and increase savings. If you own a house, hang on to it. If you have a job, do your best to keep it. If you still own shares, it might be best to put them in the bottom drawer for a couple of years and wait for them to come good. Selling them now will only turn paper losses into real ones.

That’s a tough call, because shares could well lose even more value before things get better, and there’s always the risk that some individual companies could disappear altogether. But, there are reasons for hanging on. One of them is the difference between property and shares.

House prices are clearly out of step with average incomes, and whatever else happens they need to come down relative to income. It is often said that property is a good investment because everybody needs a place to live, but that also means that for an economy to function everybody needs to be able to afford a place to live. In that way, property prices are tied to community income standards. Those ties can be stretched, as they are now, but can’t be broken without serious social implications.

Share prices, on the other hand, are not constrained in such a way. Share prices are set by the market in response to factors including the potential for a company to grow. Share prices reflect trading conditions and economic activity. It is not necessary for share prices to keep step with incomes or CPI to maintain social cohesion. That’s not to say there is any guarantee; there’s not. It may take a long time for the particular shares you might own to return to the price you paid, if ever. It’s also entirely possible for a bear market to continue for a long time. But those who are suggesting that it will may turn out to be overly pessimistic.

After every disaster, there’s always money to be made from reconstruction.

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