Wednesday, June 01, 2005

Herding, Helixes and a Hunch About Higher Prices

Humans are by nature social creatures. In both stock and real estate investing, this social "herding" behavior can be used to explain much of the price trending that we see, with markets often continuing to rise (or fall) for longer than would be consistent with a random walk model of price movement. In the stock market, we saw the impact of herding during both the spectacular dot-com frenzy in 1999-2000 (i.e., on the way up) and the equally spectacular bursting of the tech bubble in 2000-2001 (i.e., on the way down). In the real estate market, as some market commentators warn, recent double-digit year-on-year percentage price appreciation could prove to be too speculative for sustainability.

Just as "prudent" investment advice cautions investors against overweighting high P/E Internet stocks, real estate pundits warn homebuyers to think twice before buying real estate on either the East Coast or the West Coast of the U.S., pointing out how affordability is better in the Midwest and South where year-on-year percentage price appreciation remains in the single-digit range. In essence, whether the subject is stocks or real estate, here we have further examples of the familiar debate between value and growth, mean reversion and trending, Old Economy and New Economy, or status quo and change.

If history were to repeat itself in lock-step fashion, simply retracing its path as time and events cycle along, those in the value camp with an investment philosophy based on mean reversion would consistently outperform growth investors betting on change in the New Economy. However, since the value vs. growth debate continues to rage on, it should be clear that prices move neither in predictable cycles (mean reversion) nor in a straight line up or down (trending). A simple model that captures both types of movement is a forever-ascending helix. Civilization and markets do cycle around (i.e., history repeats itself) but at the same time humans do learn and markets do tend to advance in secular fashion (i.e., we make progress and markets rise).

Based on this helical model of human achievement and market prices, I have a hunch (i.e., it's difficult to "prove" but I intend to provide some "evidence" in later posts) that over the long run a) Internet stocks will run much higher than Old Economy stocks, and b) coastal real estate will outperform inland markets. There will, of course, be times when markets overshoot on the upside and downside (the cyclical part of the helix) due to short-term herding behavior among investors; yet, interestingly enough, on a longer time scale this social herding instinct among humans is the very element that can predictably drive seemingly overpriced markets still higher (the trending part of the helix).

As the 21st century unfolds, I envision an increasingly Net-centric future for our society with lifestyle choices and climate preferences driving profits for both a) companies successful in addressing the social needs of us all to stay "connected" to others and b) real property owners in the coastal markets experiencing population growth stronger than in inland markets. Similar to the impressive growth in population and property values in some of the world's largest cultural and financial centers over the centuries--Shanghai, Bombay, Seoul, Tokyo, New York, London, Hong Kong--I expect continuing above-average growth in large U.S. cities on the Pacific and Atlantic coasts--San Francisco/Bay Area, Los Angeles, Seattle, Portland, New York, Boston, Washington, D.C.

The investment implication here is a simple prescription: Long term, invest where the herd is heading (which is not necessarily the same as where the herd is investing)--towards a Net-centric society, with population concentrated on the West and East Coasts. Though prices of Internet stocks and coastal real estate may seem high today, the fundamentals (i.e., Internet usage and the influences of climate and geography) are, in my opinion, robust enough to continue to drive demand and prices much higher still.

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