Previous

Page - 5

Many academics are members of the "efficient markets" sect, which is premised on the idea that equity values are completely determined by fundamentals, not by Survivor Investors. Those elevated p/e ratios for equities in the late 1990s produced a debate among these academics: More earnings or a lower discount rate?
Were globalization and the New Economy increasing the long-term rate of growth of U.S. corporate earnings, or were investors using a lower discount rate because earnings are less risky and/or investors more risk tolerant? For these efficient market zealots, those are the only two options. But I think it was neither. It was Internet day traders and asset managers playing Survivor Investing.

A House Has a P/E Ratio, Too

You may not think about it when you buy a house, but it’s the same thing. The price you pay should reflect the present value of future rent. You should go through the same mental calculation in purchasing a home as in purchasing a stock. Ask yourself how much the house could currently be rented for on an annual basis. Divide the seller’s asking price by this rental number. That’s the p/e ratio, the ratio of price to earnings. If a $500,000 house could generate $25,000 in annual rental earnings net of maintenance and management, then the p/e ratio is 20.

A high p/e ratio for housing can be justified because of the considerable tax advantages that are afforded to housing. A high p/e ratio can be justified if other assets are similarly high priced, for example, if bond yields and mortgage rates are low. A high p/e ratio can be justified in regions that can be expected to experience high growth and thus rapid appreciation in rental values, just like a tech stock can have a higher p/e than an automobile manufacturer. But you are completely deluding yourself if you think there can be a long-run disconnect between a house price and its potential rental stream. That’s Survivor Investing.

Next

* Edward E. Leamer,
Director, UCLA Anderson Forecast.
Check the link for author's profile: http://www.anderson.ucla.edu/faculty/edward.leamer/pdf_files/cv.pdf