| This behavior of “dis-saving,” or cashing in their savings, is already beginning to cause a decline in the price of stocks, although the effect has gone unnoticed due to the stock market crash of 2008. No force exists in the current market to offset boomer influence on pricing. In fact, in the next ten years home sales by boomers will never be fully offset by home purchases or household formations. The current bump in stock prices, fueled by speculators, cannot inject enough fresh money into the system to replace what is being taken out by the constant aging of the boomer generation. Even in a casino, everybody eventually leaves the floor. When speculators decline in numbers during the upcoming years, probably as a result of their own self-destructive practices, stocks will continue to drop (increasing earnings-per-share in the process).The P/E RatioThe price-to-earnings (P/E) ratio is a simple abstraction, called a multiplier, used to compare the price of a stock with the earnings of the company. In the market crash of 2008, stock prices dropped dramatically from their former heights, but as the P/E ratio demonstrates, the earnings reported by the companies that underlie those stocks dropped much further.From the end of World War II to the late 1990s, the P/E ratio of the S&P 500 hovered between 10 and 20. This range delivers, respectively, from 10% to 5% corporate earnings on the price paid for the stock. Around 1997, however, the P/E ratio reached unusually elevated numbers, which remained elevated until 2002. Part of the accelerated rate was due to a surge of Baby Boomer investments driving up the overall price of the market (just as home prices were boosted by the surge of Boomers in the 1980s).Nonetheless, after the stock market crash which ended in 2002, the P/E ratio remained near 20 (see darkened bar on chart) until the last quarter of 2008, when it abruptly jumped from 25 to 60 as stock prices failed to adjust to the drop in earnings. As earnings fell further and stock prices rose (as risk takers returned, bringing more money into the market to vie for the same number of stocks) the P/E ratio continued to rise, peaking at a multiplier of 122 in the second quarter of 2009. These numbers were fueled by irrational optimism among investors, not by legitimate pricing expectations. After dramatic drops in the third and fourth quarters of 2009, the P/E ratio at the end of 2009 was approximately 23: more realistic but still too high for long-term ratios. By mid-2010, the ratio had fallen to 16, right in line with its historic link to earnings, an average P/E ratio of 16 in a range of 10 to 20.This return to market norms in 2009 and early 2010 came about due to a combination of gradually rising stock prices and dramatically rising earnings. Provided the market continues to gradually right itself, investors will soon become more tolerant of risk, and the economy as a whole will benefit. As time passes, these investors will also come to realize that there will not be another boom to rival the 1990s, and will adjust to the reality of the present situation. Their investments will reflect this realization, keeping the P/E ratio stable and low, and thus returning a measure of stability to the market.
Real Estate Applications
The real estate and stock markets are not the same, of course, but thoughtful investors will pay attention to the similarities. There are some notable differences. Real estate investors will never be satisfied with the 5% returns offered by stocks when they are at a P/E multiplier of 20. Property owners certainly do not buy real estate based on a 5% capitalization rate, a net income multiplier (NIM) of 20, as the current P/E ratio of stock indicates buyers of stocks are settling for. Problems that plague stocks, like spurts of inflation and short-term interest rates, are far less prone to affect real estate. Real estate investment pricing, in turn, is driven by capitalization issues, which must provide for the physical deterioration of property and the recovery of invested capital over time; problems that are inapplicable to the earnings of companies listed on the stock market, unless, of course, they are real estate investment trusts (REITs).
In the stock market, the price struck for a stock and paid by a buyer is expressed in terms of its relationship to the company’s earnings as a P/E ratio. Conversely, real estate prices are offered (and paid) based on the rate of return sought by the buyer, called a capitalization rate. It is only then that the multiplier—the real estate equivalent to a P/E ratio—is determinable, and this multiplier, called the NIM, is easily produced: it is simply the reciprocal of the “cap rate.” For example, a 5% cap rate indicates a P/E ratio – NIM – of 20 (see the left axis of the above P/E ratio chart).
More importantly, stock represents wealth, especially the accumulated wealth of senior citizens preparing to cash out upon their retirement. Right now, this means the baby boomer generation, and the amount of wealth available will determine that generation’s ability to influence the market, including their ability to buy and sell homes. Home sales are not solely dependent upon stock pricing, but real estate agents who fail to pay careful attention to the long-term trends in the market do so at their own peril. At the moment, those trends are not likely to inspire a great deal of market activity, even from the optimistic. |
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Very Infomative. I would like more information on this topic. I am not interested in an ongoing financial obligation.
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UOU This website is excellent. How did you arrive up witht he notion? -YG….
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