Shifting Capital Flows

Volatile Stocks:
Good for Real Estate?

When asked to predict stock prices almost a century ago, J.P. Morgan famously opined that "they will fluctuate."

How right he was! According to experts, the current market is the most tumultuous in over 70 years. Anyone with exposure to stocks -- or even The Wall Street Journal -- has witnessed huge, see-sawing moves on an almost daily basis since the first of the year.

Ignoring what's underlying these gyrations, continued volatility in and of itself has implications for future stock market prices. Namely, higher volatility increases risk, and increased risk requires greater returns. Translation: the premium investors put on company earnings, called the price/earnings or PE ratio, is likely to contract if the current period of turbulence comes to be seen as the new norm.

Arguably, this is merely the flip side of what happened beginning in the early 1980's, when the world's greatest and longest bull market began. Then, stocks benefited from a potent one-two punch: companies started to make more money, more consistently (or at least it appeared that way); and 2) investors bid up the multiple they were willing to pay for corporate earnings, due to the aforementioned consistency.

From a historic ratio in the low teens, average stock PE's expanded to the low 20's at the height of the stock market frenzy in 2000. Of course, many companies, especially high-flying Internet companies, had no PE ratio at all -- because they had no earnings!

Fast forwarding to 2008 and current market conditions, it could very well be that the price-earnings multiple is beginning a long contraction back to the low double-digits. In truth, such a shift would simply represent a regression to the mean established over a century.

So what difference does all this make, and how is it likely to effect real estate?

For stock market investors, it means that even if corporate earnings remain unchanged -- hardly a given in a recession -- valuations may shrink because the PE multiple contracts. Investors contemplating lower returns in stocks are likely to shift to other assets with better prospects.

Clearly, commodities as a class have already benefited from this shift in capital flows. However, they're hardly immune from the "Volatility Flu" -- gold and oil both just saw wicked, 10% price drops in less than three days. Meanwhile, another asset class seeing capital inflows, bonds, are now yielding practically nothing (at least the safe ones), and are hugely exposed to inflation and a weakening dollar.

That leaves . . . not much. There are always collectibles (rare cars, paintings, etc.), but it's hard to imagine billions of dollars suddenly ploughing into 1937 Bugatti's, Mattisse's etc. (there simply aren't that many of them, and they're not very liquid).

Like Dorothy, many investors may very well (re)discover that "there's no place like home." In a world where stocks can blow up in hours (Bear Stearns), and commodities like wheat and gold are best left to sophisticated traders, housing represents a relatively stable, tangible, and, dare anyone point it out today, long term investment.