1800s, the 1870s, the 1920s, and the late1980s. In each case, a rapid run-up of rents, usually preceded and accompanied by abnormally high general price inflation, was followedby declining business activity and stock prices. When thedowntrend started, it precipitated liquidations, foreclosures,and vacancies. While Kaiser’s study was of investment property, he concluded that the underlying forces in all real estate sectors are similar in their effect and timing.The conventional wisdom is that gains in stocks drive up real estate pricesbecause people have more money to invest. It has not always worked that way.
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65
Billions
432101833
1836
1856
18611877Year
1893
1926
1932
Figure 12.1 Total Value of Chicago Land Peaks and Valleys, 1833–1932.Source: Fred E. Foldvary, “Real Estate and Business Cycles: HenryGeorge’s Theory of the Trade Cycle,” paper presented at the LafayetteCollege Henry George Conference, June 13, 1991.
Using an index of REIT prices as a proxy for real estate prices, we found thatfrom 1993 through 2001, REIT prices led stock market prices. The correlationbetween changes in REIT prices in one quarter and the S&P change the nextquarter was an amazingly large −0.5. As we explained in Chapter 8, our general formula for usefulness is that the correlationcoefficient multiplied by the number of observations shouldbe greater than 10. With our formula, 36 quarters and a correlation coefficient of 0.5 is a highly useful 18. The correlation between thechange in stocks in one quarter and the change in REIT prices in the nextquarter, however, was close to zero.The average quarterly gain for the S&P 500 after a quarter in which theBloomberg REIT Index declined, or rose less than 0.5 percent, was 7 percent.That is more than twice the average 3 percent quarterly gain for the S&P during the 1993–2001 period. When the REIT Index rose more than 3 percent ina quarter, the average subsequent change in the S&P 500 was −0.5 percent.When the change in REITs was between 0.5 percent and 3 percent, the averagechange in the S&P was 1 percent.A scatter diagram of the relation between these quarterly changes appearsin Figure 12.2. Note that the quarters after declines in real estate prices tend tobe followed by big increases in stock prices (the northwest quadrant of the
S&P 500 Percent Change Next Quarter
256 Practical Speculation20
10
0
–10
–10010Bloomberg REIT Index Percent Change in Quarter
20
Figure 12.2 How Real Estate Leads Stocks: REIT Performance versus S&P500 Performance in Next Quarter. Source: Niederhoffer Investments.
chart). Similarly, the large increases in real estate prices tend to be followed byrelatively muted moves in stock prices (the southeast quadrant).We next looked for cyclical patterns in real estate prices themselves. Wefound, going back to 1971, a significant −0.35 correlation between the return inREIT prices in one year and the return two years later. When REITs gained 25percent or more in a year, the gain falls to an average 8 percent two years later.Eight declines in REIT prices occurred during the period from 1971 to2001, and the REITs returned 24 percent, on average, two years later (seeTable 12.3). Results show total return, including reinvested dividends andcapital appreciation.
We Make a Bearish CallIn February 2002, we put these findings to use in the market. The divergenceof some 65 percentage points in favor of the REITs in the period 2000 to 2002had been the greatest in recorded history. Not only were real estate prices at ahigh, but business conditions were at a low, the September 11, 2001, destruction of the World Trade Center having exacerbated an economic pullback thathad been under way since March.
Table 12.3
PeriodDec-01Dec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94Dec-93Dec-92Dec-91Dec-90Dec-89Dec-88Dec-87Dec-86Dec-85Dec-84Dec-83Dec-82Dec-81Dec-80Dec-79Dec-78Dec-77Dec-76Dec-75Dec-74Dec-73Dec-72Dec-71
Annual REIT Returns Two Years after Decline
REITReturn (%)16.026.0−6.0−19.019.036.018.01.019.012.036.0−17.0−2.011.0−11.019.06.015.025.032.09.028.031.0−2.019.049.036.0−42.0−27.011.0
Period
Dec-01Dec-00Dec-99Dec-98Dec-97Dec-96Dec-95Dec-94Dec-93Dec-92Dec-91Dec-90Dec-89Dec-88Dec-87Dec-86Dec-85Dec-84Dec-83Dec-82Dec-81Dec-80Dec-79Dec-78Dec-77Dec-76Dec-75Dec-74Dec-73Dec-72Dec-71
REITReturn (%)
16.026.0−6.0−19.019.036.018.01.019.012.036.0−17.0−2.011.0−11.019.06.015.025.032.09.028.031.0−2.019.049.036.0−42.0−27.011.0
REITReturn TwoYears afterDecline (%)
16.026.0
12.036.0−2.0
28.0
49.036.0
Source: Niederhoffer Investments.
257
258 Practical SpeculationIn 2002, dividends of REITs were averaging 7 percent a year. These dividends obviously looked very good compared with alternative yields of about 1.5percent on stocks and 2 percent on Treasury bills. Advocates for REITs point todividends as an overriding positive for the industry. Yet this same argumentwas made in 1987, when REITs underperformed the S&P 500 by some 50 percent. It seemed clear to us that highly leveraged REITs would be unable tomaintain their current dividend payouts in a weak real estate market. After all,office vacancies in 2001 had increased at the greatest rate on record and werewidely expected to be heading to heights unseen since the late 1980s—levelsthat had been followed by dismal performance for REITs, bankruptcies, andrelated bank failures. At year-end 2001, the national office vacancy rate was13.1 percent, up from 6.2 percent in the third quarter of 2000. The Grub &Ellis brokerage was projecting a 15 percent vacancy rate by the end of 2002.Increasing vacancies are a crucial negative signal. A definitive PricewaterhouseCoopers study indicates that rising vacancy rates are the most accuratesignals of a decline in prices. The study was based on 20 years of prices forevery major metropolitan statistical area broken down by type (i.e., office,apartment, industrial, residential, hotel, and warehouse). Numerous academic studies backed up the conclusions of PricewaterhouseCoopers.We saw numerous other early warning signs that REITs were headed fora decline:• Fuzzy accounting: A report from Green Street Advisors, the most scholarly and studious firm in the field, found evidence that REIT funds foroperations, the measure most investors look at, were lower in 2001 thanin 2000, but that some REITs were excluding nonrecurring charges andwrite-offs from their financial statements, making results appear betterthan they were.9 We feared that some REITs, especially highly leveragedones, would not be able to maintain their dividend payouts in a weakreal estate market.• Popular books: A trip to the local Barnes & Noble revealed that real estate was the hot new growth area in the financial publishing industry.Investing in Real Estate,10 Rich Dad, Poor Dad,11 and J.K. Lasser’s Real Estate Investing12 were selling particularly well. Because of the long leadtimes involved in writing and publishing, book sales tend to be a lagging indicator of what is likely to make money. We were reminded ofthe rash of Dow 40,000 and day-trading books that proliferated at themillennium, just before the stock market’s debacle.• S&P 500 membership: The arbiters of Standard & Poor’s, after intensive lobbying from the real estate industry, added three REITs to the
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S&P 500 Index in late 2001 and early 2002: Equity Office Properties,Equity Residential Properties, and Plum Creek Timber Company. Asour colleague and CNBC Money editor Jon Markman has shown, however, stocks removed from the index typically outperform the ones thatare added.13• Doc Greenspan: The much-venerated Fed chairman had been tootingthe horn for real estate, noting in his February 28, 2001, monetary policy report to Congress that the wealth effect from rising residential realestate values had cushioned the economy from the violent declines inconsumer spending triggered by layoffs and the drop in the stock market. We could not help but wonder why a wealth effect from real estatevalues was more virtuous than a wealth effect from Nasdaq stocks,which had elicited the chairman’s full firepower in 1999–2000. Wehad also learned to be wary of Greenspan’s Mr. Magoo-like knack forbad timing. His sightings of irrational exuberance in the stock marketin December 1996 at Dow 6437 and inflationary danger in the marketin 2000, well past the end of the capital spending boom that engendered the Nasdaq’s rise, are only two outstanding examples.A January 31, 2002, Wall Street Journal article noted that 2001 hadbrought the sharpest jump in office vacancies ever recorded.14 On top of allthis, well-connected, highly respected firms with every reason to be as friendlyas possible to the REIT industry were beginning to lower their opinions ofreal estate’s prospects. Merrill Lynch, in a December 19 research comment,saw “muted price appreciation” in “this late-cycle sector.”
Wrath of the REIT AdvocatesDespite all these warning signs, REIT shares had held up extraordinarily well.At the end of February, the Bloomberg REIT Index was still up 17 percentfrom its year-earlier level. All things considered, it seemed like a good time forus to predict that a decline in REIT prices was imminent. Yet when we presented our findings in a series of columns for CNBC Money in February andMarch 2002,15 we were vilified like never before in our career. Letters fromthe REIT industry poured in for us and our bosses. Some samples of our emails:Victor, Victor, Victor . . . It was with horror that I read the piece that you and Laurelwrote on REITs. . . . Your article belongs in the trash compactor! (Barry Vinocur,editor-in-chief, Realty Stock Review and Property magazine)
260 Practical SpeculationYour REIT article was the most poorly researched and written article on this sector in the past eight years. . . . I’m not alone in this view. I’ve spoken to ten institutional clients this morning who are all incredulous that this article saw the lightof day. (Louis W. Taylor, senior real estate analyst, Deutsche Bank Alex Brown)
Mr. Taylor added that the industry’s reaction to our article indicated our“incredible arrogance, unprofessionalism, and cowardice,” and that we andour editors were all a disgrace to our profession.Those comments were typical of what we received from experts who knowinfinitely more about the subject than we do. We also received a raft of criticalcomments from what appeared to us to be more typical readers, such as:It is people like you that create panic and people begin to sell. I hope your poorjudgment falls on deaf ears.
The article elicited some notice on the Motley Fool real estate messageboard, where “fatuous” was a typical comment. Our credentials received considerable negative scrutiny—it was noted with derision that Laurel had been anaerospace reporter and that Vic had played squash. “This guy is as bad a columnist as he was a hedge-fund operator,” one wrote. We would have added onlythat most of the companies Laurel covered from 1989–1994 had been sold off,and that the hardball squash game that Vic ruled for a decade is extinct.
Untimely OptimismThe torrent of vituperation directed at us is instructive in many ways. Aseconomists who study the subject invariably conclude, contractions are likeliest just when developers and banks are most convinced that business conditions warrant expansion. Real estate decisions take a relatively long time toreach the marketplace, and when they do, it is all too likelythat conditions will have changed dramatically. Rent rates anddemands fall at the same time. Similarly, just when investorsare most optimistic about real estate securities, the peak is near. The psychological bias at fault in these upheavals is called the “recency effect.” The lastfew levels and the last few changes are remembered too vividly, to the exclusion of other changes that have since faded from memory. A related problemin decision making is the human proclivity for going along with the herd atexactly the time it would be appropriate to stand alone.Even those who agreed with us had bones to pick. Ron Kaiser reviewedour work and pointed out that we omitted “the single most impressive reason
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for being bearish: REITs usually trade at about 20 percent below net assetvalue, and they are currently closer to 100 percent of NAV.”More typical was the disagreement of William Wheaton, a principal inthe respected Torto Wheaton real estate consulting firm, source of the beststatistics of office vacancies and completions going back to 1967. In a February interview, he told us he believes that the real estate markets are “reallyhealthy.” He predicted an upturn spurred by economic recovery in the middle of this year.But office vacancies continued to climb in the third quarter. On September 19, 2002, Torto Wheaton predicted that demand would not rebound untilmid-2003.16Jon Fosheim, cofounder of Green Street Advisors, an independent research house that produced a study we had cited approvingly, also found manyareas of disagreement with us. Fosheim noted that while REITs had had twovery good years, this followed on the heels of two years of underperformance,and that REITs had done about as well as the S&P over the past 5- and 10-yeartime frames. He emphasized that while his firm had indeed noted accountinghocus-pocus, nothing suggested that REITs were any worse in this area thanother companies. His most important quarrel with us was the contrary evidence provided by “the collective opinions of thousands of investors on MainStreet who risk their capital every day buying and selling real estate . . . weplace high faith in their opinions as to how to price REITs.” Apparently Fosheim, whose clients include major mutual fund firms, institutional investors,and REITs themselves, was not overly enthused by our conclusion that REITswere headed for a sharp contraction.We were reminded of the old Hungarian proverb that, roughly translated,means, “The more he talks about his honesty, the more I check my change.”This would seem to apply when industry analysts talk about correcting negative statistical information.
The Ground ShiftsPurely by coincidence, of course, and without citing us, the Wall Street Journalran an article on Monday, February 25, 2002, entitled “Commercial Real Estate May Damp the Economy.”17 After reciting a litany of negatives that madeour own piece sound quite muted by comparison, whom should they trot outto confirm the negative but Green Street Advisors. “We haven’t seen the bottom,” Green Street analyst John Lutzius told the Journal. “Quite a lot of jobs
262 Practical Speculationwere lost in the last quarter of 2001, and that may not be reflected yet in thevacancy and rent statistics.”Doubtless because of our shocking bearish views, Laurel was asked to defend our position on Money Matters Radio Network. Talk show host BarryAlexander, president of the $2.5 billion New England Advisory Group, saidright off that he had been telling people since 1997 to buy REITs. Perhaps asa sop, the show’s detail man later told Laurel he liked what we said about thevacancy factor. “We are located in an office park. Two years ago you wouldhave to circle the parking lot forever to find a parking space, or park in theoverflow lot well over a football field away. Today, you can park almost anywhere you like at any time of day. Also, the ‘space for lease’ signs are poppingup faster than the crocuses.”We felt vindicated when REIT indexes dived two months after we ran ourinitial article on February 14, 2002. Between April 12, 2002, and October 9,2002, the Bloomberg Office REIT Index fell 24 percent.Altogether, the developments in REITs reminded us of the remarkableweek in March 2000 when Vic received five proposals, including two from hisdaughters, to fund Internet companies. We promptly predicted a crash in Internet stocks, based on the law of supply and demand, in a column that turnedout to be our last for the publicly held Internet site we were then writing for.The crash came as if on cue; thestreet.com’s Internet index, DOT, peaked onMarch 10, 2000, and by mid-2002 had lost 95 percent of its value.The near-unanimous negative sentiment that our article on REITs elicitedis all too typical of what happens at market peaks. Such virulent reactionsexplain why the public consistently loses, over and over again, much moremoney than it has any right to lose. While we can look at thisresistance to even a whiff of pessimism at the top as a beautifulmanifestation of the necessary order of things, whereby thepublic contributes the maximum to the market’s upkeep, it was sad to see allthese forces once again coalescing to induce all too many to ruination.
13
MARKETTHERMODYNAMICS
Nature’s rules rules apply for all particles and interactions.—Gordon Kane, Supersymmetry: Unveiling the Ultimate Laws of Nature 1
M
ost weeks, Vic knows exactly how his youngest daughter, Kira,spends her time. There are four hours a day when she is not atschool, eating, or sleeping. In those four hours, she has to complete an hourof sports (usually a game of squash with Daddy), an hour of ballet, and anhour of piano practice. She also has an hour for play, which she often spendsdiving for dollars with friends in the pool.The distribution of these pastimes can be expressed by a simple formula,which we shall call the Kira Equation:Sports + Ballet + Piano + Diving = 4Occasionally, Kira requests that she be allowed to trade ballet practice forsports, or what have you, and being an agreeable father, Vic is alwaysamenable. But he insists that she make up the deficit in the weeks thereafter.263
264 Practical SpeculationThus, by counting how many hours Kira has spent on any three activities, Viccan figure out how many she has spent on the other one. And by looking atKira’s activity record in one week, Vic can generally predict the distribution ofher activities in the weeks to come.The Kira Equation was inspired by an ingenious example invented by theNobel Prize winner Richard Feynman. In Feynman’s story, a mother is hunting for wooden blocks missing from her son’s 28-piece set. She uses someclever calculations of mass to discover all the hiding places: a little locked box,the space under the bed, and the fish tank, where the water level was the giveaway. Feynman used the example to illustrate the law of conservation of energy,one of two basic physical laws (the other being the law of entropy). The laws ofconservation of energy and entropy are the cornerstones of our understandingof everything that happens in the physical world and much else in life.But what does physics have to do with the understanding the market? Itcan be as useful as it is in helping Vic guide Kira in making the most ofher time.
Market Experiments versus “Market Feel”Many traders tell us that they base trading decisions on their“feel” for the market. Unfortunately, we have no market feeland are forced to compensate by using scientific research andmethods to help with our decisions. Our own trading style hasbeen developed over four decades of continuous use of the scientific method.Of the many ways people have devised over the centuries to understandhumanity’s place in the cosmos, science holds a special place. In essence, science is a process of inquiry designed to ask and answer questions about thegreat principles underlying the physical world. Progress in science has led toenormous increases in human betterment. One of the best things people cando to improve their investing results and their lives is to become familiarwith the truth-seeking method that has permitted these achievements: gathering facts, discovering regularities and patterns, forming theories, and testing predictions. Odd though it may seem, given the scientific method’ssuccesses, the investment field has not universally embraced it. ThomasKuhn observed in his 1962 classic, The Structure of Scientific Revolution, thatscience does not always progress smoothly. Members of the old guard tend toresist ideas that threaten paradigms on which their livelihoods and reputations are based. Too often, a new theory’s acceptance results not from acclamation, but from funerals.
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This regrettable tendency to reject fresh insights shows up in spadesamong market gurus. In science, great breakthroughs are often made byscientists attempting to verify theories that turn out to be untrue. The first capacitor, the Leyden jar—a device that could store large amounts of electricalcharge—was invented by Pieter van Musschenbroek, a physicist and mathematician in Leyden, Netherlands, as he tried to prove the fluid theory of electricity, which turned out to be a fallacy. This fruitful trial-and-error method isseldom practiced in the investment field, however, because few propositionsare ever stated in verifiable form. Francis Bacon is credited with saying, “Truthemerges more readily from error than from confusion.” Too much market forecasting is built on a framework of confusion akin to the forecasts of palm readers and storefront psychics. Kuhn’s summing-up of the state of optics beforeNewton is apropos: “[O]ne may well conclude that, though the field’s practitioners were scientists, the net result of their activity was something less thanscience.”In sticking to the scientific method, we have attempted to follow in thefootsteps of generations of scientists who sought the spark for new ideas fromthe stores of knowledge accumulated in other disciplines. Although academicscience is conventionally divided into the four major disciplines of physics,chemistry, biology, and earth sciences, the natural world recognizes no suchboundaries. Inventions and concepts often resonate far beyond their field oforigination. The invention of the microscope, a triumph of optics, opened upfor biologists and chemists worlds of objects invisible to the naked eye. Einstein’s grasp of geometry and certain invariances of right-angle triangles led tohis discovery of the theory of relativity. Such cross-pollination among disparatefields is so frequent and important that we have collected some outstanding examples in Table 13.1.Social sciences, too, have benefited from cross-pollination. Adam Smith,the Newton of economics, modeled his idea of the invisible hand on a parableby the Dutch poet Bernard de Mandeville, The Fable of the Bees; or, Private Vices,Publick Benefits. Given the accelerating pace of interaction among the sciences,it is likely that more and more great discoveries will be made within a few generations as scientists apply rules and ideas from other fields to their own.Entirely new disciplines can be expected to emerge. We already have seen thesciences of optics, electricity, and magnetism merge into electrodynamics,then combine in turn with other strands of knowledge into modern particlephysics. Is it possible to think of a surgeon in 50 years’ time who will be unfamiliar with genetics, electronics, and computer science?Can investment in stocks be guided by fundamental concepts used to explain the structure and energy of matter? We think so. Experiments already are
Table 13.1
Idea Transfers
William Harvey
Blood circulationWilliam Harvey, physician to James I and Charles Iof England, discovered that the heart pumpedblood through the body and that veins containedvalves, a model drawn from the principles ofhydraulics.
1628
Alessandro Volta
The electric batteryVolta theorized that electricity was created by thedifference in potentials between two dissimilarmetals after reading about the involuntarytwitching of a dissected frog’s leg when it cameinto contact with two different metals.
1800
Horace Wells
AnestheticsWells, a dentist, was observing people inhalinglaughing gas at a carnival, when one man fell andinjured himself. Remarkably, he did not appear toexperience pain. Wells decided laughing gas mightbe useful in his dental practice.Left-handed and right-handed moleculesPasteur noticed that salts of racemic and tartaricacids had different effects on polarized light. Thisled to his discovery that organic compounds existin mirror image forms at the molecular level.
1844
Elihu Thompson
Welding with electricityIn an experiment to demonstrate the movement ofelectricity as a spark, Thompson noticed two wireshad fused, welded together.
1876
Hilaire de Chardonnet
RayonChardonnet, while developing photographic plates,spilled one of the chemicals. Wiping it up, henoticed it made silk-like strands. Within six yearshe had produced artificial silk (Rayon) fromcollodion.
1891
Wilhelm Röntgen
X-raysRöntgen’s studies with cathode ray tubes led to thediscovery of X-rays.
1895
Henri Becquerel
RadioactivityBecquerel discovered radioactivity whileinvestigating substances made phosphorescent byvisible light.
1896
Louis Pasteur
266
1848
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Table 13.1 ContinuedAlexander Fleming
Watson, Crick,Wilkins, and Franklin
PenicillinHere’s an example of a cross-fertilization thatliterally drifted in. Fleming was growing a plate ofStaphylococcus bacteria when a spore of a rarePenicillium notatum mold wafted up from a labstudying fungi one floor below. When Flemingreturned from vacation two weeks later, the Staphbacteria were flourishing, except for the spot wherethe penicillin mold had taken hold.DNA double helixCombined insights from biology, physics,chemistry, and x-ray crystallography led to thediscovery of DNA’s form.
1928
1962
proceeding. Charles Sanford, a former president of Bankers Trust, developed aconcept he dubbed “particle finance” based on the science of the particles thatmake up matter. Sanford identifies and splits the different risks embodied in asingle financial instrument to gain protection from the unpredictability of financial events—the equivalent of chaotic phenomena in physics. A practitionerof particle finance, instead of simply buying the collection of risks called abond, might choose a different risk mix. His portfolio might consist of Xamount of credit risk, Y amount of exchange risk, and so on.2In another experiment, Charbel Tannous and Alain Fessant of the Universite de Bretagne Occidentale in Brest, Belgium, used combustion modelsfrom high-energy physics to predict future values of stocks. The professorsobserved that some stocks tend to jump suddenly after a long period of stability, in the same way that combustion sometimes seems to occur spontaneously. Noting that ignition takes place when fuel concentration reaches acertain level, the professors modified fuel combustion equations by replacingfuel concentration with share prices of real companies.3
Money as EnergyMarkets are filled with different energies and transfers. Money can beviewed as energy, efficiently moving from person to person in free capitalmarkets. Like energy, money exists in many different forms: currency, land,goods, stocks, and bonds, to name a few. Commerce transfers this wealtharound the world from person to person and country to country in a circular
268 Practical Speculationflow of goods, labor, land, and capital between households and businesses.This simple model can be expanded to include the effects of governmentand international trade. Just as potential energy exists in the world ofphysics, potential wealth energy exists in the form of oil wells yet undiscovered, seeds stored in farmers’ sheds, and technologies visualized in inventors’ minds.In physics, the concept of energy transfer is expressed in the first twolaws of thermodynamics.These special laws provide the foundation for all other laws governing thephysical world. They are fundamental to understanding not just physics, butlife. In the following pages, we set forth some variations on the themes embodied in these two great laws.
The First Law of Thermodynamics: Conservation of EnergyThe first law of thermodynamics—conservation of energy—has nothing to dowith preserving trees, avoiding gas guzzlers, or turning off the lights whenleaving the house. In essence, the first law says that while all real-worldprocesses involve transformations of energy, the total amount of energy staysconstant, or is “conserved.” The first published expression of the law came in1842, when Julius Robert Mayer, a German physician, asserted that energycould not be destroyed, only transformed. Mayer demonstrated the equivalence of heat and other forms of energy. Albert Einstein extended Mayer’swork in the twentieth century by showing that matter and energy also areequivalent.Social scientists such as Herbert Spencer used the conservation conceptto develop a theory of human society. Marxists appropriated it in an attempt tobolster the fallacious argument that economics is a zero-sum game. For purposes of practical speculation, the first law provides an excellent workingmodel of financial markets, with numerous fruitful hypotheses and insightsinto market forces.Conservation of Energy, Variation 1: The Kira EquationLet’s go back to Vic’s daughter, Kira, and the equation of her extracurricularactivities. We will substitute U.S. bonds for Ballet, U.S. stocks for Sports,German bonds for Piano (in honor of Beethoven), and the U.S. dollar forDiving.
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Current Daily S&P 500 Change (points)
We will move from the realm of time, where Kira’s minutes add up, to thatof two-dimensional counterbalancing moves in market prices. When the