Real estate absorbs a sizable portion of
everything that people spend -- some 10% to 20% of typical business
operating expenses, and at least one-third of a typical family’s
income. It's a factor in all production and spending
decisions.
The
Speculator
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The Speculator
Sinking real estate means rising
stocks
When real estate investment trusts head down, it's often a
signal that the market is about to head up. Guess what? After a good
run in 2000 and 2001, REITs may be signaling a turn.
By Victor
Niederhoffer and Laurel Kenner
Like the grinding of tectonic plates beneath the
Earth’s surface, changes in real estate prices affect everything
above, causing earthquakes, volcanic eruptions and continental drift
in business activity and the stock market. Fortunes are made and
lost in such primal events as the 27% decline in real estate
investment trusts from 1997 to 1999, the similar drop of 1989-1990
or the even worse crash of 1972-1974.
We’ve
discovered some surprising short-term patterns in the interrelation
between stocks and real estate that may help investors find profits
among the shifts.
Right now, these patterns are bullish for
stocks -- but not for real estate investment trusts (REITs).
Both writers of this column have first-hand experience with
real estate’s power to turn life upside down. Laurel’s father, a
REIT executive, lost wealth and his livelihood in the 1972-1974
collapse. Vic’s parents were similarly brought to their knees during
the Depression. After losing their stake in the stock market, the
family tried to rebuild by buying depressed properties at
foreclosure sales in the ‘30s. When that, too, proved impossible,
speculation became a dirty word until the late ‘50s, when Vic
gingerly made his first steps into buying mining properties on the
American Stock Exchange. Almost four decades later, a financial
collapse in Thailand brought about by massive overbuilding forced
Vic to close his hedge fund -- and mortgage his house.
But
it’s a rare wind that blows no good. Laurel took up journalism to
pay the rent, putting aside a satisfying but financially unstable
career in classical piano. After his disaster, Vic re-examined and
rebuilt his speculative foundations. In 1999, our paths crossed in
one of Manhattan’s glass-and-steel boxes -- and with crisis in the
air, we arranged a meeting at a Korean grocery to discuss
collaboration. (The meeting, as it turned out, took place at a nadir
in the REIT cycle.)
Real estate
drives everything
Real estate’s wide-ranging impact on
life and investment stems from its immovable nature; it is fixed in
quantity. Everything that happens takes place on real estate. It’s a
major source of wealth for businesses and consumers. It absorbs a
sizable portion of everything that people spend -- some 10% to 20%
of typical business operating expenses, and at least one-third of a
typical family’s income. It's a factor in all production and
spending decisions.
Several theories attempt to pinpoint the
cause of real estate cycles. David Ricardo and Henry George observed
in the 19th century that rents and land prices rise when business is
good, absorbing the extra profits generated. The price rise is
exacerbated as speculators jump in near the top. Eventually,
business staggers under the burden, rents and mortgage payments go
unpaid and land prices crash. But hope springs eternal, and real
estate eventually becomes cheap enough to let entrepreneurial
business plans pencil out.
Going back into history, the
demise of great speculative land operations -- the South Sea Company
in England and the Mississippi Company in France -- created
wholesale financial panics. The memoirs of the great 18th-century
speculator Giacomo Casanova, whom it is always proper to recall on
Valentine’s Day, detail how he used such excesses for the mutual
benefit of himself and his amours. In modern days, who can
forget 1980s Japan, when the few acres around the imperial palace in
Tokyo commanded a higher price than all the real estate in
California? Or the 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 Dekko of Korea’s Ajou
University and colleagues at University of California Berkeley note
that many explanations of real estate cycles feature “the greedy
developer” and “the bumbling lender.” This is because bankers
apparently like to lend so long as business conditions are good,
while developers have a complementary tendency to borrow so long as
credit flows. The resulting oversupply brings down
prices.
Nobel Prize winner Joseph Stiglitz, asked about the
causes of Southeast Asia’s market collapse in a June 2000 interview
with The Progressive, went to the heart of the problem: "The biggest
problems were the misallocations of lending to speculative real
estate, and risky financing, especially borrowing short-term debt on
international markets."
One up, the
other down
In recent years, real estate and stock prices
have often seemed to be acting as substitutes for each other. As the
stock market almost doubled from 1997 to 1999, REITs tumbled. When
the stock market tanked in 2000, REITs started to outperform. Real
estate is the second-largest U.S. investment category by value after
the stock market, and it’s inevitable that the two would be related.
An Internet search brings up hundreds of thousands of articles that
explore the relationship between the two.
At present, the
relation may be at a turning point. Returns for the 147-member
Bloomberg REIT index, including dividends, amounted to 29% in 2000
vs. -9% for the S&P 500 Index ($INX),
and 13% in 2001 vs. -12% for the S&P. Never far behind the cusp
in switching after good performance, the sages at Standard &
Poor’s on Oct. 9 replaced Texaco in their big-cap index with
Equity Office Properties (EOP,
news,
msgs),
the nation’s largest REIT.
These developments remind Vic of
the week in March 2000, when he received five proposals to fund
Internet companies, including two from daughters. He promptly
predicted a crash in Internet stocks, based on the law of supply and
demand, for a column that turned out to be our last for the publicly
held Internet site we were then writing for. Vic’s antennae are
again buzzing, this time for REIT stocks.
The Speculators
will write about individual REIT stocks next week. For now, we have
taken pencil to paper -- a good start with all subjects of this
complexity -- and arrived at an amazing short-term relation between
REIT prices and the S&P 500.
How
they relate
The conventional wisdom is that stock market
cycles affect real estate prices. As stocks go up, this reasoning
goes, there is more money for real estate investment. Yet it hasn’t
worked that way recently. From 1993 through 2001, REIT prices have
led stock market prices. The correlation between the change in
stocks in one quarter and the change in REIT prices in the next
quarter is close to zero. However, the correlation between changes
in REIT prices in one quarter and the S&P 500 change the next
quarter is an amazingly large -0.5. Since the correlation
coefficient ranges from -1 to 1, this number is highly significant
on both a statistical and practical basis.
The average
quarterly gain for the S&P 500 after a quarter in which the
Bloomberg REIT Index rose less than 0.5%, or declined, was 7%. That
is more than twice the average 3% quarterly gain for the S&P
during the seven years.
When the REIT index rose more than 3%
in a quarter, the average subsequent change in the S&P 500 was
-0.5. When the change in REITs was between 0.5% and 3%, the average
change in the S&P was 1%.
With the current quarter about
half over, the REIT index is down 0.23%, on the knife’s edge between
the category that’s highly bullish for stocks and the one that’s
neutral. If the index closes the quarter with a loss, the
expectation for stocks in the next three months would be a 7% gain.
Of course, the individual outcomes here are highly variable, with a
standard deviation about twice as great as the average. Stay tuned
for our updates.
How real estate leads stocks
| REITs vs. S&P 500 in following
quarter |
| Quarter |
Bloomberg REIT Index % Chg in
Qtr |
S&P 500 % Chg Next Qtr |
| Dec-01 |
2.29 |
* |
| Sep-01 |
-4.44 |
10.29 |
| Jun-01 |
9.21 |
-14.99 |
| Mar-01 |
-1.84 |
5.52 |
| Dec-00 |
1.76 |
-12.11 |
| Sep-00 |
6.72 |
-8.09 |
| Jun-00 |
8.58 |
-1.24 |
| Mar-00 |
0.67 |
-2.93 |
| Dec-99 |
-2.97 |
2.00 |
| Sep-99 |
-9.91 |
14.63 |
| Jun-99 |
8.13 |
-6.63 |
| Mar-99 |
-6.17 |
6.71 |
| Dec-98 |
-4.35 |
4.65 |
| Sep-98 |
-11.67 |
20.87 |
| Jun-98 |
-5.73 |
-10.30 |
| Mar-98 |
-1.26 |
2.91 |
| Dec-97 |
-0.27 |
13.53 |
| Sep-97 |
11.35 |
2.44 |
| Jun-97 |
3.58 |
7.02 |
| Mar-97 |
-0.70 |
16.91 |
| Dec-96 |
18.18 |
2.21 |
| Sep-96 |
5.13 |
7.77 |
| Jun-96 |
2.51 |
2.49 |
| Mar-96 |
0.62 |
3.89 |
| Dec-95 |
1.87 |
4.80 |
| Sep-95 |
2.02 |
5.39 |
| Jun-95 |
3.25 |
7.28 |
| Mar-95 |
-2.48 |
8.80 |
| Dec-94 |
-1.81 |
9.02 |
| Sep-94 |
-3.61 |
-0.74 |
| Jun-94 |
-0.14 |
4.15 |
| Mar-94 |
0.86 |
-0.34 | |
Source:
Bloomberg LP
Applying the usual statistical techniques for
determining the accord of these numbers with chance, we can conclude
that it is highly unlikely -- say 1 in 100 -- that these results
were due to chance variations alone.
Our findings on these
short-term patterns do not, of course, represent an attempt to
ignore the long-term economic damage caused by big speculative
blowouts. We merely seek to emulate Casanova in taking advantage of
speculative opportunities as they arise.
End note
In accord with the bullish
predictions of our last two columns, the Speculators are maintaining
a long position in the health-care portfolio they recommended Jan.
3. We are somewhat embarrassed by the 21% decline in the portfolio,
but this regrettably is par for the course when negative news
arises. The Biotech HOLDRs Trust securities (BBH,
news,
msgs)
traded on the American Stock Exchange have fallen 10%. Fortunately,
our loss is cushioned by a profit of 25% in one month on our
previous recommendation of similarly situated stocks, and the 10%
gain we had from shorting the HOLDRs as a hedge. With the whole
biotech group this much out of favor, it’s an ideal time to buy
more.
There was recent insider buying in biotech companies
that qualifies them for purchase in our tested system that
retrospectively yielded 50%-a-year returns. “We are therefore adding
Bruker Daltonics (BDAL,
news,
msgs),
SuperGen (SUPG,
news,
msgs),
Sybron Dental Specialties (SYD,
news,
msgs),
Varian (VARI,
news,
msgs)
and Valentis (VLTS,
news,
msgs)
to our portfolio. Genzyme Transgenics (GZTC,
news,
msgs)
also had insider buying, but we already own it. In light of the
bullish forecasts we derived from our recently reported equity
mutual fund/money market ratio and the poor performance at the
beginning of the month, we are planning to increase our own exposure
to these stocks from 100% of our funds available for risky
speculations to 150%. Since the market has set an unsustainable run
of bullish days this week, however, we will wait for some weakness
to put the new positions on.
Our recent columns on humility,
hubris, skyscrapers and energy benefited much from your comments.
Kindly send your feedback on these and other areas to us at dciocca@bloomberg.net, and
we will be pleased to send you updated numbers on the current state
of the indicators that go into our current bullish forecasts. We
answer all queries.
At the time of publication Victor
Niederhoffer and Laurel Kenner owned or controlled shares in the
following equities mentioned in this column:
Valentis.
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