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Warren Buffett made the convincing case (to me) that equities will increase about 7% per year over the next decade.

(http://www.fortune.com/indext.jhtml?channel=print_article.jhtml&doc_id=205324)

Reits now yield about 6.5% and I expect a 3% increase in FFO, due to inflation and a little growth, giving a total return of about 9.5%. If the market is efficient this situation cannot endure.

Of course I could be wrong; maybe equities will return 10% in the future or maybe I'm overestimating REIT total returns, but let's assume that I'm right and the spread contracts. Perhaps REITs will normally sell at higher NAV premium than in the past, perhaps NAV will increase as cap rates come down, perhaps REITs will issue more stock, overbuild, and otherwise destroy value. Probably a combination of all of the above.

Maybe the present spread came about because most investors still believe that equities will return 10% over the long run and when they realize that those returns are not realistic, they will look more kindly on REITs. Then the spreads will contract. First some pundits will write more about REITs, new REIT mutual funds will be created to accommodate those new to REITs, and more stock will be issued. This might go on until the total return of REITs reaches equilbrium with equities, i.e. until REITs have an expected 7% total return. Assuming that 3% of this return is from inflation and growth, that means that the dividend will yield about 4%.

I'm not predicting, or even hoping, that the above will occur. If the REIT yield drops to 4%, intellectual klee will argue for decreasing the allocation to REITs in the klee household, whereas emotional klee will say "What, sell the REITs that gave you so much comfort and warmth during those horrible years 1n 1999-2000, that promised to take care of you in your old age. Would you sell your son?"

Please, please tell me why yields will not sink down to the 4% region so I can get sleep peacefully.

Respectfully,

klee12
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How I feel about yields going to 4% depends a great deal on whether it is the numerator of the denominator of the dividend/price ratio that does the adjusting. I could sleep just fine as long as it's the denominator.
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Jim Luckett wrote <<I could sleep just fine as long as it's the denominator.>> Well, I too would much prefer denominator going up, but would you lighten up on your REITs?

klee12
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Would I lighten up on my REITs if they went to 4% via price increases.

Yes, I think I would. For one thing, with the 75% capital gain that it would require to bring that about, I might start figuring on spending some of the principal some day (since I would have so much of it and it would be earning so little) rather than present plan to just live off dividends.

For another, if REIT dividend yield came down to 4% while prospective returns on competing assets stayed where they are, it would present diversification opportunities. I don't love being so heavily invested in REITs -- right now and for the past 3-and-a-half years, there was just nothing else that seemed competitive to me.
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Is there some unwritten understanding that WEB does not include REITs in "equities"?
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Reitover wrote <<s there some unwritten understanding that WEB does not include REITs in "equitie"?>> I'm not sure that it matters, since REITs make up a very small part of all equities that I believe he was talking about.

klee12
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Some more arguments in the klee household. Emotional klee said "Stick with REITs, they're safer because of their predictable cash flow, less chance for accounting gimmicks like Enron, sort of like bonds". Intellectual klee said "Good points. But the market being efficient will price this into the stock, and the total return should be less than equities to take the safety into account. The yield may go below 4%".

Jim Luckett wrote << I don't love being so heavily invested in REITs>> Neither does intellectual klee12, but emotional klee12 seems to have fallen in love.

klee12
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Make that, "Intellectually, I don't love being so heavily invested in REITS."
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>>Please, please tell me why yields will not sink down to the 4% region so I can get sleep peacefully.<<

Since REITs compete with the private real estate market for properties, this 38+% fall in dividend yields would imply either a very large premium for REITs, a large decline in cap rates for all commercial real estate properites, or some combination of the two.

For cap rates to fall significantly and stay there, alternative investments such as the 10-year treasury, natural resources, foreign markets, emerging markets as well as US big-caps, mid-caps, small-caps, etc. would all have to be unattractive on a risk/return basis vs. real estate. Does this sound likely?
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I've written before on why comparing stocks to real estate leads to erroneous conclusions, so I won't do it again. See post 10904 if interested.
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The bubble in REITs could go on a long time, just as it did in tech. Thus the dividend% would be bound to fall. I went through this in the early 1990s. In fact, although many REITs are setting all-time highs, they are not all that much above their early 1990 highs (maybe 20%) so we may be in the early stages of the bubble.

brucedoe
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FWIW, I happen to have the Feb 2, 2002 Nareit chartbook on disk, so I looked up historical dividend yields of equity REITs. The low was around 5.5% in late 1997 early 1998. That was just before a bear REIT market.

Let me reiterate that I'm not predicting or hoping for 4% yields. I'm trying to reconcile my beliefs in a 7% return in equities, a 9-10% total return for REITs going forward, and efficient markets. It seems something has got to give and what that something is is disturbing my sleep.

klee12

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<<Let me reiterate that I'm not predicting or hoping for 4% yields. I'm trying to reconcile my beliefs in a 7% return in equities, a 9-10% total return for REITs going forward, and efficient markets. It seems something has got to give and what that something is is disturbing my sleep.<<

We have discussed this before and I put in my 2 cents then, so I guess I will again. It appears to me that the Something That Has Got To Give is well into the giving: the falling stock market. When WEB first made his 7% prediction (2 years ago?) the markets were all much higher than they are now. Even if WEB were right then (and I suspect he was being a little optimistic at 7%) we might now be looking at 8 or 9% from this point forward to finish out the 20 years.

The second thing That Has Got TO Give is REIT prices. As other equities have fallen hard, REITs have rallied strongly, reducing their projected returns. They have also caught up to and passed their underlying NAVs.

The third Thing That Has Got To Give is real estate valuations. The recession hardly made a dent, so in one sense, that too is already well underway. Expect cap rates to fall (at least relative to interest rates) and consequently real estate prices to rise.

Finally, the fourth Thing That Has Got To Give is interest rates. They will probably go up, raising the return of bonds. (That will also tend to raise cap rates for real estate but my prediction is that cap rates will fall relative to interest rates.)

Those four things, all of them already in progress IMO, will cause the various returns to converge. Which is not to say that no part of the market will ever get crazy again, high or low. It will, both high and low, without a doubt. I even wouldn't be totally amazed to see your 4% yields on REITs. But if I do, while my heart may still be with real estate, my money will be elsewhere.
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Robfinkii writes <<I even wouldn't be totally amazed to see your 4% yields on REITs. But if I do, while my heart may still be with real estate, my money will be elsewhere. >>

Yeah...but if I understand what you are saying, your portfolio value will have almost doubled to get average yield to 4%. My heart would be with real estate too but, are you suggesting that with REIT yields at 4% treasuries might be at 5%?
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<<Yeah...but if I understand what you are saying, your portfolio value will have almost doubled to get average yield to 4%. My heart would be with real estate too but, are you suggesting that with REIT yields at 4% treasuries might be at 5%? <<

That would be a wild ride. I think that a run-up of that much would be "crazy," albeit possible. REIT equity would be issued like mad in order to buy up real estate. Real estate would be fetching such high prices that real estate development would go through the roof. In other words, a real estate bubble. We've seen them before and probably will again. But I would sell into that rally, I think.

I predicted a rise in interest rates, so maybe treasuries at 7% instead of 5%? But here I am just speculating. It is entirely possible to have the returns fall so low on competing investments that I would stick with REITs yielding 4% - especially if the trend toward lower payout ratios (and hence faster growth) continues. As Jim suggested, such low expected returns would certainly encourage consumption - no harm in eating seed corn if it isn't going to sprout anyway.

And, while I'm at it, a real 4% yield (4% plus inflation) is historically a reasonable return. So maybe I won't sell and can keep the "Spending my Kids' Inheritance" bumper sticker in storage after all(not that I have a hope of retiring until they're all thru college anyway).

.....Rob
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Is this the "what if pigs could fly" thread?
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Tjberk, you make a good point about the supply response to an increase in the price of commercial real estate, but it's a point that's less true in some markets than others. And your assertion that real estate markets are isolated from stock markets and interest rates flies in the face of economic logic, I believe. Why would anyone supply the capital to build commercial real estate without comparing prospective returns of that investment to what they would expect to get buying a bond or stock in some other kind of business? All capital asset markets compete with each other for the next dollar of capital investment, and that creates an equilibrating force driving their returns to equality.

We've had this discussion before, but, what the hell-- if it was fun before, why would we do it only once? Here's the conventional economist's view of how capital markets work and inter-relate (which I agree with):

If capital is free to move among markets, then the central tendency is to equalize estimated future returns to a dollar of new capital investment across all asset classes, with (A) all the following adjectives modifying “returns”-- (1) risk adjusted (2) after-tax (3) inflation adjusted (4) liquidity adjusted -- and (B) the measure of such return being the internal rate of return, not the “cap rate” in real estate lingo or earnings/price ratio in stock market lingo.

One immediate observation is therefore that if real estate is slower growing than stocks, an equal internal rate of return for the two asset classes will mean real estate cap rates are higher than stock market earnings/price ratios. This will be more true, the more optimistic folks are about the growth of non-real-estate-company earnings. (The internal rate of return is whatever discount rate produces a present value of net investment equal to zero, in other words, the rate that equates present value of what the investor must put in to what the investor gets back).

Now let's look at the adjustment mechanism that creates the tendency to equalize estimated future returns as measured by IRR. Contrary to what you said, I think it does predict and increase in real estate prices when real estate returns are perceived to exceed those of other assets. Whenever perceptions shift so that an asset class is perceived to have a higher prospective IRR than other assets, capital flows to that asset class, to get the higher return. The market for that asset responds in two ways (as any market responds to a shift in the demand curve): There is a output response (more is supplied) and there is a price response (the asset price is driven up). Both of these responses drive down the IRR for that asset. When more of the asset is produced, competition in the end-user market related to the asset drives down profits. (If more office buildings are built, rents growth is reduced, as you said. If more dot.coms are launched, they compete away some of each other's profits with free shipping and discounts to consumers, in the competition for market share.) But in nearly all markets there is also a price response to increased demand for the asset. The cost of land, building materials and construction labor rises when there is more construction demand. The salaries of programmers and dot.com executives rises when investors throw lots of money at dot.com startups. This increase in the cost of the asset also helps to drive IRR back to equality with other capital assets, as investors must pay more for a unit of capital.

The relative size of the price response vs. the quantity-supplied response (slope of the supply curve, in other words) varies across markets. When demand increases for Manhattan office buildings, there is a big increase in the price of land and existing buildings, and a small increase in square footage. When demand increases for suburban office space in Georgia, there is a big increase in square footage supplied and a very small increase in the price of land and existing buildings. If the quantity response is large ( and the price response is small), supply is said to be highly elastic; and if the price response if large (and the quantity supplied response is small) that called inelastic supply. The supply of dot.coms proved to be fairly elastic. The supply of oil has proved to be fairly elastic, despite attempted cartelization.. The supply of apartments in Boston has proved to be very inelastic.

I think we on this board have perceived that real estate IRR's are higher than stock market IRR's, because we are less optimistic than most investors have been about future stock market returns. If most investors came around to the Buffet view that stock market returns are likely to be around 7%, and if real estate returns were perceived to remain at 10-14% (modestly leveraged), I think it would set in motion an adjustment process that would raise stock market returns (through lower stock prices, and reduced investment in non-real-estate capital goods) and lower real estate returns (through increased real estate prices and increased new construction). As described above, capital would flow to real estate and this would cause a lot of new construction in markets where that's easy to do and a lot of increase in real estate prices in markets where it's hard to build new.

If we're expecting that type of adjustment, we should seek out REITs that own assets in high-barrier-to-entry markets. Barriers to entry can be legal (zoning, environmental), physical (no vacant land and no vacant buildings) or economic (existing building re-sale prices well below replacement cost, so there is lots of room for them to rise before a meaningful quantity response can begin).
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Gee, so many things to comment on and so little desire to spend the time to do it in a coherent way -- so here are some random thoughts.

-- what does one man's opinion (WEB) have to do with the pricing of anything, and I'm sure he would be the first to admit that he could be way off? I believe WEB's point was that the stock market is overvalued so that it will underperform it's historic returns over the next 10 years. What does this have to do with real estate? Can't stocks simply go down to bring things back in line without real estate going up? Can't real estate be fairly priced while stocks are over-priced so that only one asset class would need to adjust?

-- there seems to be a contradiction in your thesis. Since you believe in the efficient market thesis, that money is free to flow among all investments, that people act in a rational way, and that all information is priced into the markets, then all asset classes should already be priced to offer equivalent risk adjusted returns right now. So what would be the point of moving money from one asset class to another except that one decides he wants to take more or less risk. Shouldn't real estate already be priced to provide equivalent returns with the stock market according to your thesis?

-- even if stocks return 7 percent over the next 10 years, the businesses that make up the stock market may earn 11 percent annual returns on equity. Why would you use the 7 percent figure to deduce real estate prices and not the 11 percent figure which is actually the returns that businesses as an asset class are producing on invested capital?

-- you talk a lot about perceptions. Who knows, except in hindsight, what the popular perception is. Perceptions have nothing to do with reality. In the 1970s, real estate and gold way outperformed stocks. I would assume that in 1970 the perception was that each market was fairly valued, and according to the efficient market theory they were. But reality was totally different. Why would this decade be any different. Who knows what real estate will do over a 10 year period, and using a prediction about stocks to predict real estate returns just adds one more wild guess to an already wild guess.

-- this idea that capital is allocated efficiently is a myth. I think the NASDAQ, NIKEI, Gold and Japanese real estate bubbles show this. Very few people know what they are doing when making investment decisions. Why would anyone buy 30 year bonds at 5.5% if the stock market always beats this over any 30 year period by quite a bit. Money may be theoretically free to flow to the highest return, but in reality it does not. Banks loan money. They don't switch asset classes every time they perceive one might outperform the other. Did banks shift to buying stock with their capital in the early 90s or did they continue to make loans? Most insurance companies buy bonds and are not switching into real estate, gold or stocks every few months based on their perceptions of getting the highest return. My mother buys CDs and never stocks and has her whole life. She doesn't scour the different asset classes looking for the highest return. The owner of an office building doesn't sell his property because he sees the stock market outperforming real estate over the next 6 months. Some capital is seeking the highest return over the next week, some the next 3 months, some over the next 3 years and some over 30 years. Their allocations of capital may be totally at odds with each other depending on their goals. Even if each individual or institution is trying to act rationally, it doesn't mean that the whole is rational.

-- I find economic theory interesting as well, but economic theory predicts full employment, no recessions and everything in equlibrium. Each part of classical economic theory may make sense, but the sum of the parts fails to describe the whole. Economists are no better at predicting the future than anyone else, and half the economists disagree with the other half. The best economic theory to believe in when making longer term investment decisions is "reversion to the mean".

-- I agreed with your basic thesis in my post. I said the long run return on commercial real estate is about the same as stocks, but over any given decade it can be very different (the 1970s for example). Nobody really believes in the efficient market hypothesis, even you Jim who is overweighted in real estate. Some people believe in it theoretically, but nobody believes it in their gut.

-- Jim, I thought that one thing we agreed upon is the over-importance placed on the flow of funds; that everytime some asset is sold, it is bought at the same time at the same price by someone else. How does it work that money flows out of the stock market and into real estate?

-- Wouldn't you agree that real estate demand, the cost of materials and labor, economic strength, and inflation are going to be far more important in affecting real estate prices than what happens in the stock market?

Things were slow today at work, so I was able to show that I can be as verbose as you. Clearly we have too much time on our hands. Feel free not to respond if you choose, as this discussion is likely to go in circles.
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tjberk writes << Very few people know what they are doing when making investment decisions>>

Since you are talking macro impact...do you, or does anyone else have a meaningful data input as to just how much effect we individual stock investors really have in what is possibly a mutual fund world?
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<<Since you are talking macro impact...do you, or does anyone else have a meaningful data input as to just how much effect we individual stock investors really have in what is possibly a mutual fund world? >

Individuals are the ones that make the decision to allocate investment money to mutual funds. Mutual funds are individuals.
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-- what does one man's opinion (WEB) have to do with the pricing of anything, and I'm sure he would be the first to admit that he could be way off? I believe WEB's point was that the stock market is overvalued so that it will underperform it's historic returns over the next 10 years. What does this have to do with real estate? Can't stocks simply go down to bring things back in line without real estate going up? Can't real estate be fairly priced while stocks are over-priced so that only one asset class would need to adjust?

This is a great point, WEB is most certainly talking about the S&P 500 in my opinion, this is what he has compared himself to forever. I have never really put a lot of net worth into the S%P stocks, so it does not concern my returns, or me.
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tjberk wrote <<what does one man's opinion (WEB) have to do with the pricing of anything>>. I agree that one should not accept opinions on authority, but rather on reasoning. I found his arguments convincing

http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=205334

was written in November of 1999, and

http://www.fortune.com/indext.jhtml?channel=print_article.jhtml&doc_id=205324

was written in December of 2001. Both articles are well worth reading IMHO.

In his 1999 article he pointed that the Dow Jones averages were essentially flat between 1964 and 1981, and it soared from 1981 to 1998. One major factor was that interest rates went from 4% to 15% in the first period and dropped to around 6% in 1999. In the 2001 article he assumes GDP to grow at 5% (includes inflation) and return will be 7% (perhaps because of 2% dividends). He assumes there will be no help from interest rates or from undervaluations of equities. His two articles were very persuasive to me, and even if he has a 50% chance of being correct it seems better to be conservative.


I'm inclined to think that the REITs will outperform the general stock indices over the next 10 years and will do so with less volatility. I'm inclined to think that the recent movement of money into REITs reflects the beginning of an appreciation of the advantages of REITs. I'm also going to have to rethink what an efficient market is. I just can't ignore the main argument for efficient markets, namely that most money managers do not beat the averages over a long period of time.

Respectfully

klee12


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tjberk:
<<Their allocations of capital may be totally at odds with each other depending on their goals. Even if each individual or institution is trying to act rationally, it doesn't mean that the whole is rational.
<<

Actually, with a large population it doesn't require that the individuals be rational. If 50% of the population are so dumb that their actions are incomprehensible and essentially random, and 25% are making decisions which are for other than economic reasons, and 25% are reasonably intelligent and make decisions for economic reasons - that 25% is way more than is needed to keep the allocation of capital relatively rational as the rest are essentially random and, hence, irrelevant.

I, as Jim, like the efficient market theory. I don't believe in it much, however, except to say that it is exceptionally difficult to outguess the market. That is really all the efficient market theory can claim - anyone can see that a single stock can vary by 20% in a single day with no news. How can that be "efficient?" A story which is hardly news comes out about PGE on a Wednesday, by mid-day the third following trade day (Tuesday) the pfd was down 30%, by close the next day half of it was gained back. No, the "efficient market" is a better predictor than any one individual and a tendency towards rational pricing. It is not actually efficient, except by comparison. Emotional Jim and I both flay the market with our (so far and, for me, recent (as I missed the tech bubble both up and down)) unusually superior judgments.

Also, remember even an efficient market can have bad information. This is especially true over longer periods of time.

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TJBERK, who is one of my favorite people on this board because of the thousands I have made on stocks he brought to my attention, writes:

-- what does one man's opinion (WEB) have to do with the pricing of anything, and I'm sure he would be the first to admit that he could be way off? I believe WEB's point was that the stock market is overvalued so that it will underperform it's historic returns over the next 10 years. What does this have to do with real estate? Can't stocks simply go down to bring things back in line without real estate going up? Can't real estate be fairly priced while stocks are over-priced so that only one asset class would need to adjust?

Yes.

-- there seems to be a contradiction in your thesis. Since you believe in the efficient market thesis, that money is free to flow among all investments, that people act in a rational way, and that all information is priced into the markets, then all asset classes should already be priced to offer equivalent risk adjusted returns right now. So what would be the point of moving money from one asset class to another except that one decides he wants to take more or less risk. Shouldn't real estate already be priced to provide equivalent returns with the stock market according to your thesis?

No. If something changes, like people adopting reduced expectations for future stock market returns, then the previous equilibrium is gone and a new one exists in which equilibrium prices and quantities for various assets might be very different from the past. No contradiction -- just a changing world.

Also, the efficient markets hypothesis is not the hypothesis that everything is perfectly priced all the time. That's manifestly false and foolish -- disproven in a nanosecond by seeing the historic volatility of the stock market. Rather, it is the hypothesis that the pricing errors, and when they will be corrected, cannot be systematically identified and dated (which is to say, identified and dated with accuracy above chance level) except in hindsight. But, most people's understanding of the efficient market hypothesis will never progress beyond what they wrongly infer from the name.

-- even if stocks return 7 percent over the next 10 years, the businesses that make up the stock market may earn 11 percent annual returns on equity. Why would you use the 7 percent figure to deduce real estate prices and not the 11 percent figure which is actually the returns that businesses as an asset class are producing on invested capital?

If (A) they can still produce 11% on a new dollar of invested capital, then WEB's prediction is just for a contraction of P/E and not a slowing of earnings growth. On the other hand, if (B) the 11% is only the average return to capital at historic cost while the marginal dollar invested no longer produces (by his prediction) an increment to profit of 11 cents, but rather 7 cents, then something big has changed. Is he saying (A) or (B)? You could get stock market returns of 7% through either scenario, but I think (A) favors the prediction that all the adjustment to the new expected return would occur in the stock market -- stocks would fall to a new base level from which 11% returns could resume. But (B) has more implications for real estate, because in (B) we are talking reduced expected returns to incremental real investment in non-real-estate assets, which implies the expected 10-14% returns we now see in incremental real estate investment can't persist. Thanks for posing that question. I think it sheds light to analyze it.

-- you talk a lot about perceptions. Who knows, except in hindsight, what the popular perception is. Perceptions have nothing to do with reality. In the 1970s, real estate and gold way outperformed stocks. I would assume that in 1970 the perception was that each market was fairly valued, and according to the efficient market theory they were. But reality was totally different. Why would this decade be any different. Who knows what real estate will do over a 10 year period, and using a prediction about stocks to predict real estate returns just adds one more wild guess to an already wild guess.

Right. There is no systematic way to predict asset price changes that will be correct above chance level. Completely agree. We are doomed in this effort, yet we persist.

-- this idea that capital is allocated efficiently is a myth. I think the NASDAQ, NIKEI, Gold and Japanese real estate bubbles show this. Very few people know what they are doing when making investment decisions. Why would anyone buy 30 year bonds at 5.5% if the stock market always beats this over any 30 year period by quite a bit. Money may be theoretically free to flow to the highest return, but in reality it does not. Banks loan money. They don't switch asset classes every time they perceive one might outperform the other. Did banks shift to buying stock with their capital in the early 90s or did they continue to make loans? Most insurance companies buy bonds and are not switching into real estate, gold or stocks every few months based on their perceptions of getting the highest return. My mother buys CDs and never stocks and has her whole life. She doesn't scour the different asset classes looking for the highest return. The owner of an office building doesn't sell his property because he sees the stock market outperforming real estate over the next 6 months. Some capital is seeking the highest return over the next week, some the next 3 months, some over the next 3 years and some over 30 years. Their allocations of capital may be totally at odds with each other depending on their goals. Even if each individual or institution is trying to act rationally, it doesn't mean that the whole is rational.

Models are myths -- simple stories we construct in the hope that we can capture the essence of reality without all the complex diversity of reality that overwhelms our brains -- so you can't condemn for being myths. I think capital is more mobile than not and more driven by wealth owners seeking the best everything-adjusted return than not. A model complex enough to cover the specific behavior of your mother and my mother (okay, now I've gone too far -- no model's gonna do that -- let's say your mother and the next guy's mother) would be too complex and quirky to be useful. Every time you buy a preferred that you think is mispriced, you are betting that the central tendency of the market is toward "correct" pricing -- which is to say unjustified return differences will be erased because market participants are generally driven by rational self=interest. They aren't always, but, a model based on the assumption that they are works better than one that employs the assumption that they are mostly like your mom.

-- I find economic theory interesting as well, but economic theory predicts full employment, no recessions and everything in equlibrium. Each part of classical economic theory may make sense, but the sum of the parts fails to describe the whole.

No. It predicts that full employment is a feature of equilibrium, and that the equilibrium is stable (which means the dynamic forces in play when the economy is not in equilibrium push toward equilibrium, as opposed to away from it), but it does not predict that the economy is always in equilibrium. It does not predict "no recessions", only that in recession, forces are not in balance and that the imbalance favors restoration of equilibrium. Keynes challenged that view by proposing the idea of the liquidity trap and equilibrium at high unemployment. The emphasis in teaching economics is usually too much on understanding equilibrium and what changes equilibrium, and students may forget that we may spend most of our time moving toward equilibrium and little of our time in it, because it keeps moving. Disequilibrium is allowed to exist for finite periods of time in models of economic equilibrium.

Economists are no better at predicting the future than anyone else, and half the economists disagree with the other half. The best economic theory to believe in when making longer term investment decisions is "reversion to the mean".

I'll skip this one.

-- I agreed with your basic thesis in my post. I said the long run return on commercial real estate is about the same as stocks, but over any given decade it can be very different (the 1970s for example). Nobody really believes in the efficient market hypothesis, even you Jim who is overweighted in real estate. Some people believe in it theoretically, but nobody believes it in their gut.

Billions are in index funds. That's a lot of over-ruled guts. My gut wouldn't let me stay in index funds from mid-1998 onward. The battle between intellectual Jim and emotional Jim is well documented on this board. Emotional Jim won, to the benefit of both Jims, we see in hindsight. Yes, you are right about me.

-- Jim, I thought that one thing we agreed upon is the over-importance placed on the flow of funds; that everytime some asset is sold, it is bought at the same time at the same price by someone else. How does it work that money flows out of the stock market and into real estate?

Flow of funds in trading markets makes no sense, as you describe. I jump on that kind of talk, when no new stock is being issued or bought back by a company. But the stock market and the real estate market are not just trading markets. They are also intermediaries for real investment. I sell you a share of stock, and nothing real takes place. But when a company raises equity on the stock market and uses it to finance new plant and equipment, that's real investment. In that case, wealth flowed through the stock market into additional real capital competing in that industry, bidding up the resources that industry employs and pushing down the returns to that type of real capital. Same for real estate developers raising funds from public markets or private investors and lenders. It's real; wealth really is flowing into that form of real capital instead of some of other form of real capital, with consequences for the relative prices of the two forms of capital and the returns to them.

-- Wouldn't you agree that real estate demand, the cost of materials and labor, economic strength, and inflation are going to be far more important in affecting real estate prices than what happens in the stock market?

Not quickly I wouldn't. What happens in the stock market is big for the economy. Very big. And if we are in for a big change in stock market returns, that's a big change in a big thing. It could have a big impact on real estate demand. Real estate demand is not exogenous. It's derived from the level of economic strength; the vigor of the stock market has a lot to do with determining economic strength (and vice versa -- it's a big simultaneous system). On the other hand, this is the "If pigs could fly" thread if we are not in for a big change in stock market returns.

Things were slow today at work, so I was able to show that I can be as verbose as you.

Congratulations!

Clearly we have too much time on our hands.

I enjoy it. I'd rather write than watch TV.

Feel free not to respond if you choose, as this discussion is likely to go in circles.

I promise not to respond to your next post on this topic, how's that?

In friendship,

Jim
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even if stocks return 7 percent over the next 10 years, the businesses that make up the stock market may earn 11 percent annual returns on equity. Why would you use the 7 percent figure to deduce real estate prices and not the 11 percent figure which is actually the returns that businesses as an asset class are producing on invested capital?

Since 1960 the average growth of earnings has been 6.7%
The differential between earnings growth and equity growth can be attributed to several anomalous factors:
1. The steady reduction of the risk premium investors demand (stocks are seen as less risky then they were in past).
2. The steep decline over the last 20 years in interest rates (which narrowed the relative valuation ratio between stocks and bonds).
3. Above average earnings reported over the last decade (however, that may have been a case of smoke and mirrors than reality – going by strict accounting, earnings may actually have been no better than the long-term average).

WEB assumes, rather sensibly, that over time, equities should not grow faster than their earnings. A 5-8% nominal growth rate (general real economic growth + inflation) is a logical conclusion for stocks in aggregate – unless one believes that earnings will grow faster than the rate of GDP, or inflation and interest rates will continue to decline, or that people will be willing to pay more and more for less and less return on investment.
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I don't get the connection WEB posits between growth in earnings (per share, I assume) and growth of GDP. Let's take a simple case: 0% inflation, 0% GDP growth and we'll impose the constraint that corporate profits in the aggregate can't grow either, so as to maintain a constant distribution of national income. Companies still have profits, however, with which they can pay dividends and buy back shares. Both contribute to total return in excess of the 0% growth rate. The share buybacks result in growth in earnings per share. With leverage and a high return on investment, and a low dividend payout ratio leaving lots of room for share buybacks, the growth in earnings per share could be quite rapid. Or, the companies could invest their profits abroad in very successful ventures. No growth in GDP, because the resulting growth is offshore, but lots of growth in earnings -- maybe this last one violates the constraint of constant shares of national income, but it's consistent with no link between corporate profit per share growth rate and GDP growth rate.
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Jim,

You raised a lot of question in one concise paragraph. I'll try to answer, as I see it, some of them.

Your hypothetical model of net 0% growth + 0% inflation should also include static near zero interest rates (a situation that has been almost a match for Japan over the last decade).

Start with dividends: Yes, high dividend yield companies would be attractive and the price of their stock would therefore rise – until the yield/price ratio fell to near parity with bonds. At that point the stocks would be stagnant; unless the company increased its payout ratio and then it would continue to rise for as long as the payout increased. But since no company can pay more than it earns, it again would reach a finite limit of attraction and the equity would stop appreciating.
Share buybacks are only justified if the value of the equities is below fair value – in the scenario you constructed, most if not all would be priced efficiently, they would considered simply as a variation of a bond held to maturity (You pay X dollars for a constant rate of return over Y years). Buying back shares that are increasingly priced higher would make little fiduciary sense. Again, the company would be paying more for less and less.
And, the practical effect of stock buybacks is often overstated since the real reduction in float is mitigated by employee stock option exercise and secondary offerings – while the former may decline in such an environment, offerings are still likely to made regularly as they are the best way for a company to raise capital.
The notion of entering new markets to get around the speed limit imposed by domestic growth is a valid point – except that A. most industries find it extremely difficult to penetrate foreign markets, and B. doing business overseas incurs a number of risks, ranging from political and legal issues to currency exchange rates, etc. That risk would (should) be built into equity pricing which dampens the multiples investors will pay for those added earnings.

Finally, I can only say that going back to 1885 the correlation between corporate earnings and GDP+Inflation has been so close as to argue that for companies -- in aggregate – it is the ultimate limiting factor.
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<<Finally, I can only say that going back to 1885 the correlation between corporate earnings and GDP+Inflation has been so close as to argue that for companies -- in aggregate – it is the ultimate limiting factor. <<

Corporate earnings and investor returns are related but different. If dividends are paid or shares repurchased - that is, corporate earnings returned to the shareholders - then the investor's return will exceed the growth in corporate earnings. Indeed, consider an extreme case where 100% of earnings are paid out as dividends and there is zero growth in earnings. The investor is getting a return while earnings growth is zero.

Conversely, if new shares are being issued in greater dollar amount than dividends or repurchases - that is, shareholders are contributing to the company - then the investor's return will be less than the growth in earnings of the company. This is common in rapidly growing companies.

So simply demonstrating that corporate earnings won't grow faster than a particular rate doesn't tell us what the return to investors is - or even the return on invested capital - unless we know how much of these earnings are being somehow returned to investors. Those of us who invest in REITs certainly understand that our returns are greater than the growth of the underlying companies because of the dividends.
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Can we please get Mr. Buffet to respond to Robfinki's post 12902?
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I'll try to answer some questions based on Buffet's articles.

Jim Luckett wrote <<I don't get the connection WEB posits between growth in earnings (per share, I assume) and growth of GDP. >> In the first 1999 article Buffett referred to a chart (not shown on the linked article) that plotted percentage of corporate profits versus GDB. He says the percentage from 1951 settled in the 4% to 6.5% range. He doubts that profits can, " for a sustained period, hold much above 6%", one reason being competition. In the second article (near the end) he refers to a chart plotting the ratio of all publically traded securities as a percentage of GNP. He says "falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire. As you can see, the ratio was recently 133>> (late 2001).

In regard to stock buybacks Buffett writes (first article) "Nor can investors expect to score because companies are busy boosting their per-share earnings by buying in their stock. The offset here is that the companies are just about as busy issuing new stock, both through primary offerings and those ever present stock option".

One final point which may (or may not address robfinkii post). Buffett was speaking of equities in aggregate. To quote Buffett (first article)

Bear in mind--this is a critical fact often ignored--that
investors as a whole cannot get anything out of their
businesses except what the businesses earn. Sure, you and
I can sell each other stocks at higher and higher prices.
Let's say the FORTUNE 500 was just one business and that
the people in this room each owned a piece of it. In that
case, we could sit here and sell each other pieces at
ever-ascending prices. You personally might outsmart the
next fellow by buying low and selling high. But no money
would leave the game when that happened: You'd simply take
out what he put in. Meanwhile, the experience of the group
wouldn't have been affected a whit, because its fate would
still be tied to profits. The absolute most that the
owners of a business, in aggregate, can get out of it in
the end--between now and Judgment Day--is what that
business earns over time.

Buffett made a much better case than I possibly can. Links to the original are in message 12872.

klee12
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<<<In the second article (near the end) he refers to a chart plotting the ratio of all publically traded securities as a percentage of GNP. He says "falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire. As you can see, the ratio was recently 133>> (late 2001). >>>

is there a place we can readily find this ratio on a regular basis??
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Robfinkii wrote <<So simply demonstrating that corporate earnings won't grow faster than a particular rate doesn't tell us what the return to investors is>> I missed your point when I wrote post 12915 (it was late at night) but now after a cup of coffee I think I can make a better answer.

My understanding is that Buffett is positing a 7% investor return based on coporate growth (equity appreciation) plus dividend - frictional cost (due to transaction and management fees).

I had estimated the return for REITs to be 6.5% due to dividends and 3% appreciation. I left out frictional cost. If we assume that will be 1% then the return from REITs should be 8.5%, which narrows the gap a little with Buffett's estimates.

Respectfully

klee12
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