Avoiding “Short Term Economic Memory.”
By Chris Miller, MBA
Specialized Wealth Management
It seems that mistakes made by businesses and investors are always repeated again sometime in the future. I have named this phenomenon “Short Economic Memory.” Economic bubbles seem to happen every decade or so; where consumers are willing to pay high prices without concern for how those assets will sustain those prices. Remember tech stocks with P/E ratios of 700? Apartment buildings with 3% Cap Rates? These bubbles “burst” when the underlying assets could not sustain the values that were paid for them. The ensuing collapse caused some economic pain.
Is this the first time that it happened?
Of course not. Everyone knows about the Great Depression of 1929 to 1933, but humans have been involved in trade for over 5,000 years. Surprisingly, the internet has little information of economic conditions prior to the 19th century, (perhaps further evidence of our “short economic memory,”) but a diligent search can reveal some details. To paraphrase a famous quote; Those who forget the past are condemned to repeat it. In this article, I explore economic calamities of the past, and discover that the same problems have been recurring throughout history.
Inflation
Between 218 and 201 BC Rome helped to finance the 2nd Punic War by degrading their coinage in weight and purity. This devaluing of currency produced hyperinflation – rising consumer costs, and shrinking values for coins that are kept at home. Five hundred years later, in 324 AD, overproduction of the Egyptian Denarii led to the same result. In 1160, so much Chinese currency had been printed that it was worthless. Emperor Kao Tsung reformed the currency with a new issue, but hyperinflation had returned by 1166.
Although every event, (such as the American Civil War,) has more than one cause, (slavery, a power struggle between the states and the Federal government,) there is usually one big cause. For hyperinflation, it is deficit spending. By definition, governments engage in deficit spending when they spend more money than they earn. The extra money has to come from somewhere, so a country can either a) borrow money or b) print some more. Option a) may be the smarter choice, but one can only borrow so much money. When a country’s credit is exhausted, it may need to print more money to pay its bills – and to pay its debt service. The solution seems easy – don’t spend more than you have – but governments have been struggling with this concept for over 2,200 years now.
“Bubbles”
During 1719 in France, shares of the Mississippi Company rose dramatically in value among frenzied speculation. The company had a monopoly on trade with the China, Southeast Asia, (then known as the “East Indies,”) and France’s Territory in the New World. The company, for a myriad of reasons, could not sustain its share value and prices plummeted.
Everyone remembers the “dot com” bubble of the late 1990’s. As mentioned earlier, this is when Price/Earnings ratios in the 700’s were not uncommon. (A P/E ratio of 700 indicates that company is trading for that multiple of its annual income.) To put this in perspective; if an apartment building with a Net Operating Income (NOI) of $100,000 was selling at a 700 P/E ratio then that would indicate a value of $70,000,000 – at a CAP Rate of 0.14%.
A famous example of “dot com hysteria” occurred with Qualcomm. (NASDAQ: QCOM) This stock had ridden dot-com hysteria to a price above $500 per share – 25 times its value from a year earlier. On December 29, 1999, a 28-year old Paine Webber analyst named Walter Piecyk issued his first-ever research report on the stock. His evaluation was particularly rosy – he estimated that stock would hit $1,000 in 12 months. As frenzied investors rushed to get in, the stock went from $564 to $659 on that day. That marked the highest value that Qualcomm ever saw. QCOM trades for an equivalent of $142 today; just 21% of what investors paid in 1999.
Between 2004 and 2008, we saw the effects of a real estate bubble. Apartment complexes weren’t seeing CAP Rates quite as low as the previous example; but I did see some trading for 3% or 2% CAPs. Investors, convinced that they were “buying for appreciation,” did not seem to mind paying $2,500,000 for $50,000 of annual income, (a 2% CAP). These buyers failed to remember that commercial properties are valued by the amount of income they generate. Without rising income, the only way to sell a commercial property at a profit is through “CAP Rate compression,” or selling for a lower rate than what you purchased at. At a 2% CAP Rate, however, it isn’t very realistic to assume that the rate would go lower.
The “Greater Fool Theory” is best described as “buying something not for what it is worth, but under the assumption that somebody else will pay still more for it.” A business plan based on such a theory, rather than on solid fundamentals, is much less likely to succeed.
Invest Using Fundamentals
All of the economic disasters above happened when investors (or the bureaucrats in charge) decided that “the old rules aren’t valid anymore.” Investors were told of a “new investment paradigm” where printing money at will is no longer a problem, or that companies should not be valued on their income; but by “mouse click.” Although the way we invest; in mutual funds, limited partnerships, Tenant-In-Common properties, REITs, may have changed, the fundamentals of why we invest have not.
In any market condition, buying assets according to solid fundamentals in demographically attractive areas is always a great plan.
Christopher Miller is a Managing Director with Specialized Wealth Management in Orange County, California and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for a national real estate syndicator, and as an advisor helping clients through over two hundred 1031 exchanges. Chris has been featured as an expert in several industry publications and on television, and earned an MBA emphasizing Real Estate Finance from the University of Southern California. Call him toll-free at (877) 313 – 1868.
