s. In the market, we had the Roaring Twenties, the postwarboom of the late 1940s and 1950s, and the great bull market of 1982–2000.After each period of scientific baseball, the market was ready for a sustainedrally. Conversely, after the end of each period of home run “hitting-from-theheels” baseball, the market was ready for a drop.Before the 1990s, it was customary after a home run for the hitter to quietly run around the bases with his head down so as not to embarrass thepitcher. When he reached the plate, he might discreetly doff his hat to the fans.As the bull market of the latter half of the 1990s rolled on, it became commonfor home run hitters to indulge in a bit of trash talk, a shuffle to first base andthen a roll of the bat. Some longtime fans were appalled.Baseball did seem to have an ability to predict the market.But as with all important questions, a test was necessary.Although the beginning and ending of the expansion andcontraction periods in home runs were somewhat arbitrary(Is a one-year spike to a new high preceded by two down years a high, or atemporary reversal?), we started with five-year highs in home runs over thepast 100 years. We then looked to see what happened in the stock market thenext year.When home runs were not at a five-year high, the market went up 12 percent the next year, on average; when they were at five-year highs, the next year’saverage move was a 2 percent gain (see Figure 11.1).Next, we studied the relation between five-year changes in home runsand the next five years’ performance in stocks. The correlation was −0.20,with 20 observations, a level fairly unlikely to have occurred through chancevariations alone.Finally, we looked at the correlation of home run changes one year andstock market changes the next year. The correlation was −10 percent. The bottom line was that every extra 10 percent increase in home runs knocked 1 percent off the market the next year.Taken together, the three relations provide confirmation that overly numerous home runs presage poor stock performance.
New Century, New GameThe late 1990s differed in an important aspect from previous periods: Whilethe home run records kept coming, so, amazingly, did record strikeouts. Bill
Chapter 11 • When They Swing for the Fences, We Run for the Exits
241
160.0140.0
Percent Change
120.0100.080.060.040.020.00.0–20.01906–19119016–19219026–19319036–19419046–19519056–19619066–19719076–19819086–19919096–2000
–40.0
5-Year PeriodHome Runs Percent ChangeDow Percent Return
Figure 11.1
Home Runs and Dow Change
James attributes the conjunction of record strikeouts and homers to smaller bathandles, aluminum bats, strength training, and abbreviated pitcher motions.On the one hand, we had fundamentalist primitives who didn’t understand thevalue of compound growth (10 percent for 20 years = eightfold return); and onthe other, day traders with microterm mentalities and a quest for immediategratification that deflected us from the hard efforts required for a proper base ofoperations in the market.In keeping with our hypothesis, the market followed suit. Huge swingsthat previously might have occurred once a year became commonplace in thefirst three years of the new century.A favorite theme of ours is that the common man often provides a betterreflection of what the future holds for the market than the more sophisticatedexperts and professionals at the higher levels of the feeding pyramid. As popular as basketball and football are, baseball holds a unique position in the American psyche because it is a game that ordinary Joes and Janes can relate to.Baseball is the only sport where people of average height, weight, speed, andstrength can play at the highest level. The median height and weight of American baseball players is 5 feet 10 inches, 190 pounds—the average for all U.S.adult males.
242 Practical SpeculationAs the late team owner Bill Veeck said, “Baseball is the only game left forpeople. To play basketball now, you have to be 7 feet 6 inches. To play football,you have to be the same width.”It is not just that people of average physique can rise to the top in baseball. Baseball is geared to the future volitions and tastes of the average Joe. Because markets themselves are in many ways affected by the normal activitiesof the average person, baseball provides a forecast of the market and life aswell as a reflection of current times (see Table 11.2).From Mark Twain in the nineteenth century to Jacques Barzun in thetwenty-first century, everybody agrees that baseball reflects American society.Paul Dickson found the thought so obvious that when he was putting togetherBaseball’s Greatest Quotations, he rejected all observations along those lines.1For Mark Twain, baseball was “the very symbol, the outward and visible expression of the drive and push and rush and struggle of the rising, tearing,booming nineteenth century,” as he put it at an 1888 dinner at Delmonico’ssponsored by Albert Goodwill Spalding, an early impresario of the game.More than a century later, in 2001, Major League baseball played to some 75million fans, more than any other sport.Baseball has always reflected America’s sorrows and flaws along with itsgood. Abner Doubleday, who would become a heroic general in the Battle ofGettysburg, invented the game in 1839 at Cooperstown, New York. AfricanAmericans were barred from the game, a taboo not broken until Jackie Robinson played for Brooklyn in 1944. A strike closed the gates in the recession yearof 1974. The World Series was postponed as the nation mourned the attack onthe World Trade Center on September 11, 2001, and the resumption of play sixdays later was seen as a necessary step toward getting back to normal. Newspapers noted, for once without cynicism, that President George W. Bushwatched the first two games of that Series at Camp David with his family, andthat he was in New York for Game 3 to throw the first pitch. It was a strike, andNew Yorkers gave the president a thunderous cheer. “It means a lot that he’shere today. It shows that this guy is a real man,” Al Meditz, 58, a mail carrierfrom Rego Park, Queens, told the New York Post.After all the ribbing Bush received about his inability to speak with propergrammar, his short work weeks, and his supposed general lack of intelligence(he graduated in the top half of his class at Harvard Business School and received an MBA while Vic was there), one can imagine that his pitching wouldhave been the object of great ridicule in any other circumstances.The only other two presidents to attend a World Series game, Ronald Reagan in 1980 and Calvin Coolidge in 1920, did so at the beginning of giganticbull markets.
Table 11.2
Time Line of Baseball and Financial Markets 1792–2001
Baseball
Date
Markets
1792
Five securities traded
1829
380,000 shares traded
1830s
Railroads dominate
1836
Trading prohibited in streets
First formal rules created
1845
First official game between twoclubs
18461853
Complete statement required
First league
1857
First admission fee (50 cents)
1858
First betting scandal
1865
First permanent home for NYSE
First all-pro team (salaries $1,400)
1869
All shares must be registered
Nat ’l Association of Baseball Players
1871
Specialists are created
First no-hitter
1875
First Nat ’l League home run
1876
First scandal in major leagues
1878
First telephone on the floor
First players’ union
1886
First million-share day
1896
Dow Jones average introduced byWall Street Journal
1903
NYSE moves to current site
1907
Wall Street panic
First modern World Series
1913
Federal Reserve System created
First game to draw 1 million fans
1920
Dow ends year at 71.95
“Lively ball” introduced; Babe Ruthhits 54 home runs in single seasonFirst player earns $50,000
1923
Babe Ruth hits 60 home runs
1927
First player hits 500 career home runs
1929
Crash
1932
Dow hits bottom
First All-Star game
1933
Securities Act of 1933
1934
SEC formed(continued)
243
Table 11.2 ContinuedBaseball
Date
Markets
First night game
1936
NYSE President R. Whitney jailed forembezzlement
First election to Hall of Fame
1936
First televised game
19391942
First $100,000 player salaryJackie Robinson is first black majorleague player
1947
1953First perfect game in World Series
Daily volume reaches 1 millionFirst NYSE member corporation
19561957
Roger Maris first player to hit 61home runs in a season
1961
First domed stadium, Astroturf
19651967
Pitcher ’s mound lowered 10 inchesStrike zone defined armpits-knees
Lowest price for NYSE membership
S&P index first calculated hourly
First woman member
19691970
First black NYSE member
1971
Nasdaq opens
First players’ strike
1972
DJIA closes above 1,000CBOE opens
First player hits 715 home runs
1974
Trading hours extended
First game to draw 3 million fans
19781982
First 100 million-share day
1987
Dow has largest one-day point drop
1988
“Circuit breakers” introduced
First game to draw 4 million fans
1991
Off-hours tradingDow tops 3,000
First non-U.S. World Series winner
1992
Average daily volume tops 200million shares
Players strike, World Series canceled
1994
Internet trading launched
1995
First Internet IPO
1996
NYSE volume exceeds 1 billion
244
Chapter 11 • When They Swing for the Fences, We Run for the Exits
245
Table 11.2 ContinuedBaseball
Date
Mark McGwire first to hit 70 homeruns in a season
1998
Barry Bonds first to hit 73 homeruns in a season
Markets
1999
Dow closes above 10,000
2000
First global indexDow has biggest up, biggest downdays
2001
NYSE volume tops 2 billionDecimalization replaces eighths
Baseball’s freedom from the tyranny of the time clock harkens back to thepastoral past recalled by the green field itself. The game originated in the dayswhen Americans began coming en masse from the farm to find jobs in thecities. The game continues at its own pace, regardless of the demands of sponsors. In the shortest game, the New York Giants beat the Philadelphia Phillies6–1 in 51 minutes on September 28, 1919. The longest game, between theChicago White Sox and Milwaukee on May 9, 1984, lasted 25 innings andtook eight hours and six minutes. While variations in tennis games oftenrange to similar multiples, the length of the matches offer no competition.We note with admiration the average American’s delight in the amazinglydetailed record of statistics concerning every aspect of the game. When a playerhits a home run, before the batter has rounded third, fans can expect a recap ofhow many similar blows have been struck, classified by inning, score, handedness of pitcher and batter, and whether the event occurred athome or away. At a 2001 Yankee playoff game co-announced byNew York Governor George Pataki, it was mentioned as a matterof routine that a certain batter had the third highest percentageof foul balls per pitch with two outs during playoffs of all American League players. If only market practitioners were to keep at their fingertips one-thousandthof that kind of knowledge about the picks of their favorite analysts—returns tobe anticipated, winning streaks, balls, strikes, and so on—the market would be afar more sensible and profitable place.
12
BOOM OR BUST?
That land speculation is the true cause of industrial depression is clearly evident. In each period of industrial activity landvalues have steadily risen, culminating in speculation, whichcarried them up in great jumps. This has been invariably followed by a partial cessation of production, and its correlative,a cessation of effective demand, and then has succeeded a period of comparative stagnation, during which the equilibriumhas been again slowly established.—Henry George, Progress and Pover ty 1
R
eal estate, fixed and immovable, might seem an ideal alternative to aroller-coaster stock market. Yet real estate prices are every bit as subjectto violent price swings. Real estate investment trusts (REITs)—the main waythat small investors can invest in large-scale income properties—have failedto measure up to stocks as long-term investments. Of course, a $17 trillionmarket that includes office buildings, residences of all types, farmland, warehouses, industrial property, and hospitals offers endless variations, niches,and opportunities for profit; and it is impossible to quantify all the benefits of247
248 Practical Speculationowning a home. The investor, however, may find that the best profits willcome from studying the patterns linking real estate and business cycles.Begin with the big picture. At once a source of wealth, a factor in business production, and a consumer good, real estate is the largest of any assetclass. Federal Reserve statistics show the value of U.S. commercial propertyat $5 trillion and U.S. residential property at $12 trillion. This compares tosome $11 trillion in stocks and $5 trillion in corporate bonds. About 50 millionpeople own homes in the United States, but that is not the end of the story.Because real estate represents about 20 percent of the assets on every corporate balance sheet, anyone who holds stocks has an interest in real estate.Americans have a large part of their wealth in real estate, probably more thanthey realize. Real estate absorbs a sizable portion of the money that peoplespend—some 10 percent to 20 percent of typical business operating expenses, and at least one-third of a typical family’s income. It is a factor in allproduction and spending decisions.Everything that happens takes place on real estate. Like the grinding oftectonic plates across the earth’s surface, changes in real estate prices affecteverything above, causing earthquakes; volcanic eruptions; and continentaldrift in business activity, personal wealth, and the stock market. Fortunes aremade and lost in such epochal real estate slumps as occurred in the periods1972–1974, 1989–1990, and 1998–1999.Several theories attempt to pinpoint the cause of real estate cycles. DavidRicardo and Henry George observed in the nineteenth century that rents andland prices rise when business is good, absorbing the extraprofits generated. The price rise is exacerbated as speculatorsjump in near the top. Eventually, business staggers under theburden, rents and mortgage payments go unpaid, and land prices crash. Buthope springs eternal, and real estate eventually becomes cheap enough to letentrepreneurial business plans pencil out.Going back into history, the demise of great speculative land operations—the South Sea Company in England and the Mississippi Companyin France—created wholesale financial panics. The memoirs of the greateighteenth-century speculator Giacomo Casanova detail how he used suchexcesses for the mutual benefit of himself and his amours. In modern days,who can forget 1980s Japan, when the few acres around the imperial palacein Tokyo commanded a higher price than all the real estate in California? Orthe 1990s tech boom that drove Silicon Valley rents and land prices up hundreds of percent? In both cases, as in so many others, disaster soon followed.Yoon Dokko, of Korea’s Ajou University, and colleagues at University ofCalifornia Berkeley note that many explanations of real estate cycles feature
Chapter 12 • Boom or Bust?
249
“the greedy developer” and “the bumbling lender.” This is because bankersapparently like to lend as long as business conditions are good, whereas developers have a complementary tendency to borrow so long as credit flows.The resulting oversupply brings down prices.2Both of us have firsthand experience with the real estate cycle’s power toturn life upside down. After first losing their stake in the stock market, Vic’sfamily tried to rebuild by buying depressed properties at foreclosure sales inthe 1930s. When the investments failed to pay off, speculation became a dirtyword in the Niederhoffer family until the late 1950s, when Vic gingerly tookhis first steps into buying mining properties on the American Stock Exchange.Almost four decades later, a financial collapse in Thailand brought about bymassive overbuilding forced Vic to close his hedge fund and mortgage hishome. Nobel Prize winner Joseph Stiglitz, asked about the causes of SoutheastAsia’s market collapse in a June 2000 interview with the Progressive, went tothe heart of the problem: “The biggest problems were the misallocations oflending to speculative real estate, and risky financing, especially borrowingshort-term debt on international markets.”3Laurel’s father, John Kenner, a mortgage banker, had a quick eye forvalue. But he lost his livelihood in the 1972–1974 REIT collapse, after refusingto sign off on what he considered to be inflated appraisals of commercial properties. Unfortunately, most of his wealth was tied up in the company REIT.
Promoting REITsREITs originated in 1880 as tax-advantaged vehicles for purchasing real estate. The tax advantages have been removed and restored over the years, butunder current law, REITs can avoid corporate taxes if they distribute at least90 percent of net taxable income. The main idea behind REITs is to givesmall investors opportunities to invest in office buildings, warehouses, hospitals, shopping centers, apartment houses, and other large properties. REITsare thus similar to stock mutual funds, which let investors hold interests in agreater number of stocks than the size of their stake would otherwise permit.In addition to the tax benefits, REITs offer improved liquidity over directinvestment in real estate because investors can easily sell their shares. Dividendreturns for REITs generally vary from 6 percent to 8 percent. REITs and real estate mutual funds experienced a tremendous surge in 2000–2002, when theNasdaq—consisting mainly of growth stocks that pay no dividends—lost threequarters of its value, and investors sought safety in dividend-paying stocks. Asof mid-2002, there were some 300 REITs, 190 of them publicly traded, with a
250 Practical Speculationcombined market value of about $300 billion, up from $13 billion in 1992. Inaddition, some 130 open-end U.S. mutual funds are devoted to real estate, withholdings consisting of REITs, real estate operating companies, or a mixture ofthe two. The largest are run by Cohen & Steers, Fidelity, and Vanguard (seeTable 12.1).Like all dynamic fields, the REIT industry undergoes constant innovationand turmoil. In the late 1990s, existing properties were transferred to umbrella REITs, but these vehicles proved unpopular because they subjected investors to unrealized gains. The turn of the millennium brought masterpartnerships to invest in assorted REIT mutual funds; some feared that thisdevelopment was symptomatic of a top.Promoters seized the opportunity to capitalize on the growing popularityof REITs. One well-publicized study after another presented REITs as idealcomponents of a diversified portfolio. It was claimed that the industry hadoutgrown the massive liquidations and boom-and-bust cycles of the 1970sand 1980s, and that the problems of those days—too much debt, too littletransparency, and too many conflicts of interest involving management—hadbeen overcome. As discussed in this chapter, real estate cycles have existed forcenturies. It is unlikely that they have suddenly disappeared for good.To objectively evaluate even past REIT performance is no easy task. It isdifficult to find good data on real estate and REITs. Many figures on real estateprices are based on appraised values, not on transaction prices. Using appraised values tends to smooth out variations in returns while creating spurious correlations. The difficulty is that transactions in thesame properties are relatively infrequent, and prices vary with respect to property type and locality.Survivor bias, as discussed in Chapter 3, compounds the data problems.The data that get reported and saved tend to relate only to properties thatmanage to escape bankruptcy, disuse, or drastic change. The National Association of Real Estate Investment Trusts (NAREIT) has data on REIT returns
Table 12.1
Morningstar Ratings
Fund
Net Assets(in Billions $)
Morningstar Rating
Cohen & Steers RealtyVanguard REIT IndexFidelity Real Estate
1.381.331.26
★★★★★★★★★★★★
Source: Morningstar.com
Chapter 12 • Boom or Bust?
251
and appraised values of real estate held by selected institutions going back to1970, but apparently only companies that have continuously provided data toNAREIT are included in the database.An exhaustive study of REIT prices by Jun Han of CIGNA InvestmentManagement in Hartford, Connecticut, and Youguo Liang, a managing director at Prudential Real Estate Investors, included data on all publicly held companies that were classified as REITs during the period 1970–1993. Han andLiang concluded that the survivorship bias of NAREIT data compared withtheir own was in the range of 2 to 3 percentage points a year.4Brokerage house reports do not help investors evaluate REITs. The threekey metrics that tend to be analyzed are:1. Price to funds from operations.2. Dividend yield.3. Discount to net asset value.These are combined by the analyst in some fuzzy way, with high values ofthe first being bearish and high values of the latter two being bullish. Thisnumber is compared with an expected growth rate, and if the comparison isgood, it generates statements like the following from a major brokerage housein early 2002:We estimate REITs are trading at 93 times our 2002 FFO estimates at a 5 percentdiscount to net asset value, and are sporting an average dividend yield of 7. We areforecasting a 5 percent earnings growth, with earnings rates likely to accelerate ifoccupancy levels rise or interest rates continue to fall. We believe the REIT institutional and retail investor base will continue to expand.
A fourth metric that REIT analysts like to use is the spread between aREIT’s dividend yield and bonds. During volatile times in the market, such asthe credit crunch of 1998 and the period after September 11, the spreadwidens. According to Bank of America research, inordinate duration of highspreads is indicative of future superior performance for REITs. The trick is todifferentiate a high spread that might illustrate undervaluation from a highspread that appropriately takes increased risk into account.
REITs versus StocksGiven all the booms and busts in real estate over the centuries, the vast divergences in prosperity among sectors ranging from apartments to farmland towarehouses, the vicissitudes of regional cycles, and the grave difficulties inobtaining accurate price data in an industry characterized by bankruptcies,
252 Practical Speculationclosings of real estate enterprises, and the tearing down of buildings—is thereanything we can say about the long-term returns from holding REITs, compared with common stock?Our studies show that, until recently, the performance of stocks andREITs had been strongly linked, with a 50 percent correlation on an annualbasis. The relation broke down in the late 1990s. REITs tumbled as the S&P500 doubled in 1997–1999, but gained 43 percent in 2000–2001 when theS&P 500 declined 22 percent (see Table 12.2).This led the REIT industry to loudly proclaim that the correlation between the two asset classes was decreasing. The implication was that institutional portfolio managers must buy REITs to achieve a proper balance of riskand reward. Such a development has been the goal of the REIT industry fordecades. One industry-sponsored study after another has tried to prove that adiversified portfolio of REITs and stocks is better than a portfolio of stocksalone. On May 29, 2001, the National Association of Real Estate InvestmentTrusts published a study by Ibbotson Associates Inc., the dean of market return statistics, purporting to show that REITs “represent a strong source of diversification for a wide range of investment portfolios by increasing returnand decreasing risk.”5Regrettably, all the careful studies of these phenomena showvery small, if any, incremental returns from such diversification.Ronald Kaiser, a principal in the Foster City, California, real estateadvisory firm of Bailard, Biehl & Kaiser, considered this exact question.6Using nine different academic and industry sources, he constructed a seriesof real estate returns from 1919 to 1997. He concluded that real estate returnswere similar to those produced by domestic stocks over this 86-year period,
Table 12.2
Performance of REITs versus S&P 500
Year
Morgan StanleyREIT IndexChange (%)
S&P 500Change (%)
Divergence(Percentage Points)
2001200019991998199719961995
12.8326.81−4.55−16.9018.5835.8912.90
−13.04−10.1419.5326.6731.0120.2634.11
25.8736.9524.0843.5712.4315.6321.21
Source: Bloomberg L.P.
Chapter 12 • Boom or Bust?
253
ranging between 10 percent and 11 percent a year compounded. This is as itshould be, since both asset classes are equity investments. Both the S&P 500and REITs yield returns that both exceed inflation and significantly outperform corporate bonds, Treasury bonds, or direct unleveraged investment inreal estate assets. Stocks certainly have the advantage over real estate in termsof liquidity, but real estate compensates with lessened within-year volatility,Kaiser concluded. However, Kaiser’s own figures show that stocks returnabout one percentage point a year more, compounded, than real estate. This isconsistent with the careful work of William B. Brueggeman and Jeffrey D.Fisher, in their excellent textbook, Real Estate Finance Investments.7Brueggeman and Fisher studied quarterly returns for REITs and other investments, including the S&P 500, from 1985 to 2000. They found that the S&P500 produced quarterly geometric returns of 4 percent, whereas quarterly returns of equity REITs were 2.6 percent. The difference of some 1.4 percent aquarter is not so minuscule as it may seem. One hundred dollars compoundedat 4 percent comes to $189 in 15 years, whereas 2.6 percent compounded comesto only $151. By comparison, institutional real estate holdings yielded 1.73 percent quarterly, corporate bonds yielded 2.24 percent, and T-bills yielded 1.4 percent. The Consumer Price Index rose 0.79 percent a quarter during this period.(The geometric mean measures the compounded rate of returns that an investorwould have earned on $1 invested in the index during the period. Portfolio managers evaluating the performance of an investment use the geometric mean,rather than the arithmetic mean, which is a simple average.)Because Brueggeman and Fisher used the problematic NAREIT data,with the survivor bias discussed earlier, their estimate suffers from an upwardbias. Considering the highly superior returns of stocks over REITs, the potential for improved portfolio performance by combining REITs and stocksseems most unlikely. Furthermore, a careful study shows that quarterly REITreturns are correlated 60 percent with quarterly S&P 500 returns. Nevertheless, after making heroic assumptions using such things as arithmetic returnsinstead of geometric returns, Brueggeman and Fisher concluded that somevery small diversification benefits could be achieved by investing in a combination of stocks and real estate.
Interlocking Gears: Real Estate, Business Cycles, and StocksAlthough investing in REITs is unlikely to significantly improve returns, thespeculator will find real estate a highly profitable field of study for understanding stock market cycles. According to a widely respected economic theory first
254 Practical Speculationput forward by Henry George and David Ricardo in the nineteenth century,business cycles are caused mainly by movements in real estate values.George and Ricardo began with the observation that rents and land pricesrise when business conditions are good. Eventually, rent-seeking landlords absorb all the excess profits that businesses can make. Businesses fall behind onrents and mortgage payments; defaults begin, and bankers call in loans. Landprices begin declining because fewer tenants can be found to lease property atcurrent prices. As these developments reduce lending for other business activities, general business conditions worsen. Just at this most inauspicious time,an abundance of new development comes on the market. Developers had broken ground on new projects back when business conditions were good, actingon the assumption that property values would keep rising. Now that the projects are complete, there are few takers.The net result is that rents and land values are driven down still further.Similar patterns are observed in many other areas—venture capital and agriculture, to name but two. In the real estate cycle, prices eventually fall to alevel low enough to permit entrepreneurs to start profitable businesses onthese properties once again. Expansion of these new businesses spurs real estate prices higher, and the cycle is ready to repeat.This simplified model is so obvious and so elementary that it almostseems naïve to present it, except that throughout history and across countriesthe cycle George and Ricardo described seems to repeat over and over again.Homer Hoyt was the first to study these cycles systematically. In One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago tothe Rise of Its Land Values, 1830–1933, Hoyt documented dramatic swings in thetotal value of Chicago land values (see Figure 12.1).8The most thorough and thoughtful real estate research that wehave found—that of Kaiser, Liang, Prudential, and the research firm TortoWheaton—confirm the economists’ hypothesis of real estate cycles.Kaiser, for example, found tremendous boom/bust cycles in investmentproperty, with peaks in the early 