Stock prices plunged in the fourth quarter (Q4) of 2018 after an unsustainable and rapid ascent from 2009 through Q3 2018. The price-to-earnings (P/E) ratio decreased to 18.1 in Q4 2018. While this is the lowest quarterly P/E ratio experienced since 2013, it is still higher than the historically applicable benchmark of 15.5.
The stock market’s P/E ratio is the reciprocal of the capitalization (cap) rate – how buyers of real estate price their investments. The most recent P/E ratio of 18.1 is equivalent to a cap rate of 5.5% – not great, as corporate expenditures are at an all-time low and margins rather large.
Expect hot investor money to leave the real estate market as the housing market slows in 2019. The stock market’s rapid decline in December 2018 precludes a slowing market heading into 2019, the next recession anticipated to arrive in 2020. For real estate, this means the ideal sell phase has passed, and a hold phase has begun as savvy investors look ahead to the next buyer’s market, still two-to-three years away.
Updated February 6, 2019. Original copy released October 2009.
Chart update 02/06/19
Chart update 02/06/19
|Q4 2018||Q3 2018||Q4 2017|
Track the current stock pricing and earnings on the S&P 500 stock pricing index, and make connections between the world of the stock market and the world of real estate.
first tuesday Analysis
The red line of the first chart above tracks pricing of the 500 stocks listed in the Standard and Poor’s (S&P) 500 index. The dark blue line in the second chart above tracks the price-to-earnings ratio for those S&P 500 companies, called the net income multiplier (NIM) in real estate transactions. The light blue shading in the top chart track earnings as a percent of total price, a figure analogous to the rate of capitalization, or cap rate, by real estate investors.
The dramatic rise in stock pricing beginning in the mid-1990s was accompanied by a huge increase in the amount of funds entering the stock market, as the aging Baby Boomer generation began to earn more and invest more heavily in stocks. In 2008, the Boomers started to retire. Now, to maintain the lifestyle they have become accustomed to, the Boomers in retirement will draw down their savings and use their accumulated wealth to consume goods and services.
This behavior of dis-saving — cashing in 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 stock pricing, and the Boomers themselves will not be in a position to reinvest the money they withdraw back into the market.
While stock ownership is a luxury, shelter is a necessity. As Boomers retire and sell their homes over the upcoming 20 years, their home sales will be offset almost completely by home purchases they will make. The Boomers grew up with the American dream of personal ownership of a single-family residence (SFR), and they will continue their inveterate habit of homeownership as they relocate in the future.
Why Boomers will still retire after the boom
The P/E Ratio
The price-to-earnings (P/E) ratio is a simple abstraction, 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 Boomer earnings and investments driving up the overall price of stocks (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 financial crisis reached its apex in the last quarter of 2008, when the P/E ratio abruptly jumped from 25 to 60 as stock prices failed to adjust to the drop in earnings. In 2009, earnings fell further and stock prices continued to rise (as risk takers returned, bringing more money into the market to vie for the same number of stocks), until the P/E ratio peaked at a multiplier of 122 in the second quarter of 2009, with annual earnings of only 0.82%.
Stock prices set adrift
These numbers were fueled by irrational optimism among investors, not by legitimate pricing expectations about the future income of these companies. After dramatic stock price 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 stability.
By mid-2010, the ratio had fallen to 16, right in line with its historic link to earnings. By mid-2011, the P/E ratio had dropped below this average, and was hovering between 11 and 15, thanks to tepid earnings and a continuing lack of confidence about growth in the economy.
Homebuyers feel ready and willing to buy, but not financially able
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.
Beginning in 2013 and continuing through Q3 2018, stock prices quickly exceeded reasonable heights, a growth rate which will prove unsustainable in the months to come. Now that stocks have dipped significantly, investors will adjust to the coming reality of the rise in interest rates over the next two-three decades as U. S. GDP increases. Investments will reflect this realization, keeping the P/E ratio between 10 and 20, and the percent earnings between 10% and 5%. Thus, a measure of stability will return to the stock market.
Real Estate Applications
The real estate and stock markets are not the same, of course, but thoughtful investors will pay attention to their relationship. There are some notable distinctions to be made between the two.
Real estate investors will never be satisfied with the 5% returns offered by stocks when the P/E multiplier is closer to 20. Property owners certainly do not buy real estate based on a 5% cap rate – a net income multiplier of 20 – the current P/E ratio buyers of stocks are settling for. Further, problems that plague stocks, like spurts of inflation and short-term interest rates, are far less likely to affect properly mortgaged real estate.
Real estate investment pricing, in turn, is driven by the components making up the cap rate investors use to set real estate prices. 2.5% to 3.2% of the return from an investment in real estate must provide for the annual recovery, over 30 to 40 years, of capital allocated to improvements on the property due to their inevitable physical deterioration (called depreciation).
Capital recovery problems are inapplicable to investments in companies listed on the stock market. They sell products which can be changed to suit the current needs and location of the population – unless, of course, they are real estate investment trusts (REITs).
REIT investment: playing the real estate game from the sidelines
The cap rate and converse P/E ratio
In the stock market, the price paid by buyers 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 cap rate. It is only then that a NIM—the real estate equivalent to a P/E ratio — is determinable.
The NIM is easily produced: it is simply the reciprocal of the cap rate. For example, earnings of 5% (a 5% cap rate) will indicate a P/E ratio – NIM – of 20. Remember: real estate buyers evaluate the property’s return on their investment by use of the cap rate; stock market investors determine their success by the ratio of earnings to quoted price.
More importantly, stocks represent stored wealth, especially the accumulated wealth of senior citizens. These seniors will soon begin to pull cash out from this store of wealth as they retire. Current trends in the stock market and future interest rates expectations are not likely to inspire a great deal of investment momentum activity in the near future, even from the most optimistic.
Home sales volume and price peaks