In more than 15 years in the financial services industry I worked with many different investment theories and with almost as many different kinds of investors. Some were extremely conservative and would only invest in bonds or CDs while others were aggressive speculators dabbling in various options strategies or betting on the futures market. There were the technical investors with their charts and graphs looking for trend lines and breakout patterns and those who followed the fundamentals such as the earnings and growth prospects of various companies. What stood out for me, however, were the stock market investors who favored growth or value. A growth investor would seek out companies that had the potential for future earnings growth, and therefore, price appreciation. The value investor would search for companies that were undervalued by the market with the idea that at some point the market would recognize the discrepancy and the stock price would rise.
While both investment theories were valid, market conditions had a tendency to favor one over the other at different times. Within the industry we were constantly on the lookout for a change in the current trend. Were we in a growth phase or was the trend turning towards value? An investor who spotted the change in trend at an early point could shift strategy and benefit from the changing climate. However there were many who could not spot the change until well after it occurred and were always chasing the market after it had shifted. A bull market run up in the stock market didn’t end gradually, it usually ended with a speculative blow-off. Inexperienced investors would jump in and the end of the bull market cycle and bid prices up to unreasonable levels. The rationale was that “it was different this time”, “it’s the new economy”, “old rules don’t apply anymore”, and hearing statements like this was usually a signal that the pendulum was about to swing back in the other direction. Most bull markets would end with a correction where prices would fall a bit and start moving up after a period of time. A much steeper drop, such as the 1987 stock market crash, usually followed a major market run-up. Novice investors would run from the market with their tail between their legs vowing that they would never buy a stock again. The value investor loves a market decline. This is where he could step in a buy solid stocks that had been oversold and suffered a price drop that was below the theoretical value of the company. These bargains could be scooped up and held on to until the next rise in market prices.
Real Estate Market vs. Stock Market
In comparing the real estate market to the stock market you have some very significant differences. The stock market has almost instant liquidity, you don’t need to advertise your stock or list it on the MLS and wait for a buyer. A stock doesn’t have carrying costs, mortgage payments, vacancies etc. What the real estate market does have is the extraordinary power of leverage. Through the use of a margin purchase you can obtain a maximum 2 to 1 leverage on a stock but in real estate a 5% down payment gives you 20 to 1 leverage. This means that if you put 5% down and your property appreciates only 5% you have doubled your money!
The parallel that we can draw from the stock market is that the bull market in real estate has peaked and we definitely saw it end with a speculative blow-off. The wanna-be investor cashed in his home equity and used easy mortgage money to buy investment property because, after all, everyone knows that real estate always goes up. This was what Alan Greenspan once called “irrational exuberance” or a frenzy of speculation. Prices were bid up to unsustainable levels and there had to be a correction in the market. Where are all of the investors and agents who claimed that it was not a problem to have negative cash flow because you were going to make so much more in appreciation? Perhaps they realize now that what they were touting wasn’t investing but speculating. These inexperienced investors are being forced out of the market, many of them never to return.
Cash Flow is King for Value Investors
The value investors are now able to come into the market and find properties at bargain prices. Cash flow is king once again and built-in equity is paramount. The current glut of unsold homes will eventually be sold and the market will return to a level of sanity we haven’t seen in a while. The get-rich-quick schemer will find a new fad to throw his money at. The savvy real estate investor will buy properties because they make economic sense, not because he is speculating on price appreciation.
What we can learn here is that while every type of investment has its’ own unique characteristics, they all share some similarities. The most notable common trait is the human element. When greed overtakes sanity and reason you will find people making rationalizations to justify their behavior. All of the excuses as to why this market is different are your signal to head for the exits and wait to capitalize on the change in the trend.
The poet, novelist and philosopher, George Santayana, said it best: