PHILIPP HOFFLIN: One of my favorites is it's just the use of words. When you read a stockbroker's report and he talks about that there is growth in a certain sector or area of the stock market, he means earnings growth. In other words, the fundamentals are improving, but a real estate agent talks about there was still growth in sub of x, y, zed, he means the price is going. It's at a top one level lower sophistication.

JOE WALKER: Hi, I'm Joe Walker, host of the Jolly Swagman podcast. I'm here with Philip Hofflin of Lazard. Phil, great to be with you. Of all the people I've met, and while you're not a housing expert, you have one of the most complete and cogent views of the Australian housing market of anyone I've spoken to. I'm very glad to be able to share you with our audience. I thought I might begin by asking you about your background because you have a nontraditional finance background. Tell us a little bit about that and how you entered the industry.

PHILIPP HOFFLIN: Yeah, it's perhaps not as unusual as you might suppose. There are quite a few people who were formerly in physics or mathematics or who are in finance. That's the way I came to investing. I love science, still take a very keen interest, particularly in physics and mathematics. I'm involved at Sydney University with that.

Yes, I did my PhD in mathematics, but I was always aware of the fact that I had broader interest in life, history, economics, and the like. The academic life means that you run the risk of knowing more and more about less and less until you end up knowing everything about nothing. It is mathematics in particular, it is very specialized and it is very narrow, and I always want to have broader interests, as I say. Being a fund manager is just it's a wonderful job, Joe, because you're an all-rounder in the true sense of the word.

We have financial companies, we have mining companies. We have insurance, sure as retailers. You need to know a lot about everything. You have the wonderful job of meeting companies and asking them, how do you make your money? What are your strategies? It's a wonderful job, and I'm very glad to have it.

JOE WALKER: Let's talk about the Australian housing market. The first thing I want to ask you is, if we accept the housing market is a complex system, in what sense can we make predictions about it? Should we just throw our hands up in the air and be nihilists about the future?

PHILIPP HOFFLIN: No, I don't think we need to do that. In my perspective, this is obviously going to come from equities. One of the benefits of that is that we have much better data and much longer history for equities. Equities too, like the housing market, it's a market. It's made up by lots of individual investors, buyers and sellers, making decisions for all types of reasons.

The good thing with equities is we have a long run history and the timescale of equities is shorter. Typically, for example, a bear market in equities is 12 months, 18 months, in housing, it's five years, sometimes six years and Japan went on for 15. The timescale of housing markets, because the turnover is lower, there's much less liquidity in housing tends to be much longer, both on the up and the down. I think that since we can learn something from equity markets as long as we can scale up that the timeframe.

Your comment about a complex system is spot on. It's my view and I think all the evidence shows this that in the short term, you cannot predict markets. Because they rely on no sentiment on momentum on all hard to forecast endogenous shocks from all sides. What equities do show though, is that while you can't forecast these things in the short term, you have one guide, it's valuation.

For equity markets are typically over one year or two years' valuation tells you almost nothing. 10%, 15% is the explanatory power of valuation over that short term. By the time you get to five years, you might be looking at 40%, 50%. 10 years plus, more than 80% of what happens in equity markets was determined by your starting valuation.

You're right in saying that complex systems are incredibly hard to forecast, but it depends on the timeframe. I think in the short term, housing is just like equities. You can't forecast it and I think 2019 has given us a great example of that. The view in April would have been very different to what it is today, but I think in the long run, valuation eventually dominates and does determine the outcome. I'm thinking it's exactly the same for housing.

Again, to get back to your comment about it being a complex system, there's the question of how we should think about complex systems because there's the so-called inside way of looking at problems and there's the outside view. Daniel Kahneman spends quite a bit of time talking about this and he says, that's a very important distinction of in terms of how we think about problems. When you deal with very complex systems, it's tempting to get more and more data and to build more and more complex models to try to capture what is going on.

Very often, this doesn't actually improve your outcomes in terms of your predictions. The reason for that is just it's just too complex. There are lots of examples like this stock markets, commodity prices, housing markets, they all form that category. What you can do though, is you can take the so-called outside view or the category view as the behavioral finance people call it sometimes, and you look at lots of other examples, where the same complex system or similar complex system has gone through its evolution.

You can say, for example when it comes to the [indiscernible] process, the job of predicting demand and supply in commodities, and then subtracting two large numbers and getting a small difference to determine whether there's excess supply or demand and therefore, the direction of prices. Well, it has a terrible record, nobody can do it. That includes the large money companies for example. What you can do, you can say, well, if prices are significantly below or significantly above the marginal cost of production, they mean revert, and you can get the timescale from the history that we have.

In that sense, I think the best way of looking at our housing markets is to say well, this has played out before. Because we do have lots of data on housing markets, I think there's an OECD database that goes back to 1970, at least, on a reasonable amount of data. You can see that in from that, that there are housing market crashes, they do exist. Almost every country, I think, in the last 40-50 years or so has had a significant housing market downturn, Australia being one of the very rare exceptions.

JOE WALKER: The first thing when you're taking outside view is to find an appropriate reference class so you think the appropriate reference class for Australia should be OECD nations post 1970?

PHILIPP HOFFLIN: It's the best fit, and yes, you're right. There's always the question of, can you go to a sample of data that is similar enough. No matter where you go in the world, they will tell you that their market is different and they have unique properties and dynamics in their own markets. I think that's again, that's the local view where you see a lot of detail. One of those is that whether you go to the UK or you go to the US, or you're in Australia, everybody says that our country has a special relationship with residential property. For us, it's much more serious than other countries and it's more important to--

JOE WALKER: It's the insert nation here dream.

PHILIPP HOFFLIN: Correct. Exactly right. I think when you talk to people in those markets, they might emphasize the differences, but in broad terms, I think that's not a bad reference class and in any case, it's the one we have. We need to use the data that we have and align for the fact that it might not be absolutely perfect, but I think it's pretty good.

JOE WALKER: Something I've been struggling with lately is how can we call something a housing bubble ex-ante? How would you falsify that claim? Like what's the test for a housing bubble?

PHILIPP HOFFLIN: There was a lot of discussion, of course, about this among central banks following the global financial crisis. The whole question of should, when you see a bubble forming, should the central bank lien against it or should it in fact, prick it and there was much debate about well, can you actually tell when you have one of these bubbles? Is there a risk that you make so many false calls that in the final analysis, the public benefit isn't there? It's an old question. Can you tell whether they're bubbles? I presume it partly comes down to semantics. If a bubble is something that goes up and then comes down again, yes, then they will pop. Bubbles.

JOE WALKER: Yeah, they'll pop after the fact.

PHILIPP HOFFLIN: How can you identify a bubble in advance? Look, I think it is very difficult. Again, and this, well, my perspective again as an equity investor, and as a value manager comes through, we do have valuations and valuations are the same. The medium term tell you an awful lot. When the numbers are completely out of whack, then [indiscernible], you have an issue.

I don't know whether you want to call it an expensive market, or use the more emotive term bubble, because it is a bit emotive. Once you look at the numbers, you can ask yourself the question, well, at what stage does a high price become a bubble? There's a continuum. It's very hard to say this is a bubble here now and it's hundred percent certified.

I'll be doing evaluations. It's something that doesn't get used very much in housing. Again, this is where I think equities can shed some very interesting light. Because just hypothetically, Joe, consider what happened if you took a whole bunch of Sydney and Melbourne real estate, residential real estate, and you put it into a trust and let's assume that trust just for simplicity has no debt, has no costs so it's a perfect vehicle, no management fees, what would the P&L look like? If your gross rental yield is about 3.50%, then you're also going to have some costs in your P&L and that might reduce that to about 2.50%. The 2.50% is, if you will, your net profit before tax yield, you tax that it becomes 1.75% roughly, and then you have your impact yield.

If you invert that, as we do in equities, you get the PE, the PE in that case is about 60 times. That's a very high PE because globally around the world, equities which are the comparable growth asset in some ways to real estate results are real asset has traded tried on average about 16 times. 60 is a very high number. Now, we would be dealing here with an ungeared asset, so it should have a higher PE multiple. It's based on gear. It's a fairly defensive asset because yes, you have the risk of your house being untenanted, but it's not an enormous risk.

Let's compare it to a safe company, an ungeared company, but even then, 60 times just seems like the wrong number. If you make the argument that for some reason, valuations can stay there, you have to assume that you can fool everybody all the time in the long run, because sooner or later the past performance, which I should talk about in a moment will be shown not have been sustainable, and eventually attitudes change and then that's when valuations change and things revert to numbers that are more defensible, and more comfortable to other asset classes.

You sometimes get people who makes the most invalid comparisons. They do things like they compare gross rental yields with dividend yields in the stock market. It's completely wrong because you have costs, you have tax and dividends are only part of your earnings, because you could reinvestment in there. You've got to do the comparison correctly. When you do that, and as we've spoken about in the past, when you look at more crude ratios, like a price to income ratios and the like, on all those measures, Australia looks too high.

JOE WALKER: Yeah. Let's take the price to rent ratio, because people often think about this is like the ratio for the housing market. The key counter argument is to say that be very careful about looking at the runoff in Australia's price to rent ratio, because real interest rates have been low and declining since the mid-1980s. If real interest rates are low and declining, the discount by which we capitalized rents into prices is lower so we should expect to see higher prices. What would you say to that?

PHILIPP HOFFLIN: It's an argument. That's of course, particularly, current today. It applies to all asset classes. Again, we have equity markets. The question becomes, is it the case that equity markets rerate dramatically as interest rates fall? Now, the number one exhibit in this is Japan, and Japan rates have gone from 5% in 1990 to negative today, and that's been accompanied by rate for equity returns.

The reason for that of course, is that when you think of the valuation formula, the simple perpetuity valuation, in the denominator, you have the difference between the discount rate and the growth rate. Now, if the discount rate is falling because demography is lower, because inflation is lower, because productivity growth is less, then all that means that nominal GDP is lower, and that in turn inevitably means lower interest rates. As long as the discount rate and the growth rate fall by the same amount, there is no impact on valuation whatsoever, because of course, they just completely offset each other. I think the mistake you can make is just to look at the spot interest rate and say, today, it's 75 basis points. Now, it's 75 basis points, all these growth assets should be valued to dramatically more.

That's not what tends to have happened in equity markets. Again, in equity markets, we have very long histories, we can go back 50 years or so, to pry episodes of very low rates. We have Australia, of course back in the '60s when interest rates were also very low including mortgage rates. The mistake to make is to assume that the growth rate has remained the same, but the discount rate is much, much lower.

Now, I want to talk to you briefly about, again, something from equity markets in 1974. In 1974, we had the all shocks, interest rates rose very dramatically. They went in Australia to say 15%, go 15%. As a response to that, the stock market crashed, and in part, this happened, because investors said, look, if I can get 13% in the bank, I want at least a 10% dividend yield. That's what they did, the dividend yield ended up being double digit, and the PE multiple was only six, seven times.

It was wrong. It was wrong for a very simple reason, because either inflation was going to remain high, in which case you're going to get enormous earnings growth, which is of course what actually happened; or conversely, inflation was going to fall again and so with rates, so it really was a case of the market on 10.50 times dividend yields. It was either cheap or cheap under both scenarios. It was given a name at the time, it was called money illusion.

In some ways, what we're dealing with today when people say rates are so low, valuations can be really high, it's exactly the reverse. Because today, we have 75 basis points cash rate. It means and I think what it means one of two things, either the RBA will hit its 2.50% inflation target, and we will have real growth on top of that, so nominal GDP still remains 5%. In that case, 75 basis points is not going to last forever.

Alternatively, 75 basis points is actually correct, because things are really bad and we're not going to get that inflation, and we're not going to get that real growth rate. In other words, the economic future is tough. You either have a situation where rates eventually have to go back up again, with all that, that implies for those who say asset prices can be inflate on low spot rates, or the economic future is really quite much tougher than we currently discount probably and rates can stay that low.

Again, the argument here would be, if you dramatically rerated growth assets, whether it be residential or equities, you would be in a situation where I think it would be expensive or expensive on the both scenarios again. I think spot rates are not a good valuation tool and I think it's very well understood in equity markets. Of course, I think you mentioned that earlier, housing markets have a lot of retail investors and retail buyers. In general there, there's an enormous difference in the sophistication between the stock market and the residential real estate market.

One of my favorites is it's just the use of words. When you read a stockbroker's report, and he talks about that there was growth in a certain sectors or areas the stock market, he means earnings growth. In other words, the fundamentals are improving, but a real estate agent talks about there was still growth in sub of x, y, zed, it means the price is going. It's at a top one level lower sophistication, rather than talking about rents are going to be very strong in this particular area.

That's the fundamentals, but there is quite a difference in sophistication between those two markets. I think that's partly behind why the timescale is different. It's liquidity, it's transaction costs, but it's also the people who actually are involved in the market that I think link from the timescale of a realty market compared to equities.

JOE WALKER: Yeah, there's another thing here, which is to say that if you argue that the discount rate by which rents are capitalized into process is lower, you're relying on a rational expectations assumption. I seriously wonder whether the present value relation is actually the model of the economy in the public's mind. I think if you ask most Australians what real interest rates were, they wouldn't know what you're talking about. If it's not low and declining real interest rates that have been driving this amazing, unprecedented runup in Australian residential real estate prices, what have the core drivers been?

PHILIPP HOFFLIN: Look, I think I agree with you about price haven't gone up because people have put different variables into complex spreadsheets, rent to value, and with assumptions on wage's growth and the ability to repay. I don't think that's happened, I think, look, clearly rates are