I’m not a stock man. Not that I don’t analyze stocks or don’t have opinions about stocks. I most certainly do. I’m a founding architect of the 1990’s Brave New World thesis about stocks, and believe that equity P/Es should be permanently higher than the 1970s-1980s, for (at least) four reasons:

(1) Business cycle volatility is in secular decline, with economy-wide booms and busts giving way to sectoral booms and busts, in the context of secularly-falling sectoral correlation. Unbridled capitalism (read, de-regulation and globalization) and technological innovation are the parents of this taming of the cyclical shrew.

(2) The “natural” rate of unemployment (also known as NAIRU or the non-accelerating inflation rate of unemployment) has fallen. De-regulation of the supply side of the U.S. labor market, manifested in both falling unionization and a falling real minimum wage (it was held constant at $3.35/per hour from March 1981-March 1990), in the context of Fed-nurtured aggregate demand get the credit for this wonderful development. A fiscal surplus has been the natural consequence.

(3) Trend growth in productivity has accelerated, reinforcing and “validating” the acceleration in economic activity fostered by a falling “natural” rate of unemployment. A process of “capital deepening,” in which each unit of labor is supported by more units of more technologically-advanced tangible/intellectual capital gets the primary credit.

(4) The promised land of “effective price stability” has been achieved, in which neither inflationary nor deflationary expectations dominate long-term investment decisions. This delightful destination, which seemed to be but a holy grail two decades ago, is the culmination of the capitalist forces noted above alongside disciplined fiscal policy and resolutely disinflationary Fed policy.

Given that evangelical pitch for higher stock P/Es, you might think that I’ve been invested to the gills in stocks, perhaps with a touch of  leverage. But you would be wrong. I’ve always had a much smaller allocation to stocks than financial planners advocate for those my age. And this has not, as they say in Texas, been a matter of my being “all hat and no cattle” in my conviction about the Brave New World thesis.

I have been fully aware that an efficient frontier constructed with historical returns for various assets, alongside my own expectations for valuation for stocks, implied that I should own more stocks. But what efficient frontier work cannot do, and was never intended to do, is capture the value of a good night’s sleep. And for me, a good night’s sleep comes from a loving family living in a comfortable home, with a low mortgage on it, and a nice chunk of liquidity in the bank (I mean, low-volatility bond funds!).  

Home Is Where the Wealth Is
   Figure 1 is a line graph comparing holdings in real estate and corporate equity across the U.S. population divided according to wealth, for the years 1992 and 1995. Each asset class is represented by a line for each year on the chart. The Y-axis shows the percentage of wealth consisting of real estate or corporate equity, while the X-axis shows the wealth percentile of the population. For those below the 25th wealth percentile (i.e., the least wealthy 25% of the U.S. population), on average there is no wealth held in real estate or corporate equity. Around the 30th percentile, lines representing both 1992 and 1995 soar upwards, to around 60% to 70% held in real estate (typically homes). Those levels drift downwards with greater velocity as the metrics approach the 100th percentile, finishing around 15%. The lines for wealth held in corporate equity only become significant around the 60th wealth percentile, at around 5% for each asset class, but then rise to around 30% by the 100th percentile, suggesting the wealthiest cohort of Americans is most heavily invested in corporate equity. The line showing real estate in 1995 is slightly lower than that of 1992 for most of the graph, while the one for corporate equity is slightly higher than its 1992 counterpart.
Figure 1
Source: Federal Reserve


The Average Household Only Wishes That Its
Balance Sheet Looked Like This
Figure 2
Source: Bureau of Economic Analysis

What Americans Own, and Who Owns It

As it turns out, I’m not all that different from the “average” American, notwithstanding the popular media view that “most” Americans are day-trading stock junkies. The picture that ostensibly “says it all” is Figure 2, which on Federal Reserve Flow of Funds data, shows that the value of corporate equity held by households has surpassed that of real estate. As a factual matter, that is true. But that putative picture of a bubble says nothing about the distribution of equity and real estate wealth across households.

Figure 1 presents the data, for 1992 and 1995, computed by the Commerce Department 1 , of who holds what: The proportion of assets represented by corporate equity and real estate by wealth percentile. While I would certainly like to have more data, Commerce will not be updating this work until next month (Mark my word, it will be the most important data release next month, even though no one is talking about it!). But I strongly doubt that the fresh data will change the story very much. After all, the S&P went up 41% in 1992-95, while the median home price went up only 8%; and the lines barely moved! During 1995-98, the S&P climbed 100%, while the median home price rose 14% (Okay, maybe I should have owned more stocks!).

What the data tell us is what our guts already know: The poor are poor and the rich are rich. The bottom 30% of the wealth distribution owns no corporate equity or real estate. In contrast, as of 1995, only the top 5% of the wealth distribution owned more corporate equity than real estate. My hunch is that at most, recent data will show no more than the top 10% of the wealth distribution holding more stocks than real estate. The fact of the matter is that the vast middle class, the sinew of America’s economy, has the bulk of its wealth in the home – just like me!

Fellow Travelers With Different Valuation

Contrary to popular perception and illusions, the economy’s health is not hostage to the stock market, but to the real estate market. To be sure, the two markets are correlated, as Fed Chairman Greenspan opined last week:

“Stock prices and existing home sales are somewhat correlated, a not altogether unexpected result, because each is affected by interest rates and presumably the gains from each help finance the other. This correlation makes it difficult to disentangle gains in overall consumer spending that are attributable to home equity extractions and to increases in stock prices. Nonetheless, the evidence suggests that, in recent years, about a sixth of the so-called wealth effect—that is, the impact of capital gains on consumer spending—stems from equity extracted from the stock of existing homes.”

I don’t happen to agree with Mr. Greenspan’s estimate that only “a sixth” of the wealth effect of recent years stems from equity extracted from existing homes. I happen to think it’s larger. But let’s say he’s right. If so, that means that at least five/sixths of the so-called wealth effect is concentrated in the top 5-10% of the country’s wealth distribution (and perhaps more, since rich people extract equity from real estate, too!).

What this says to me is that it would be a mistake for the Fed to direct monetary policy at “correcting” consumption flowing from the wealth effect of the stock market. As Mr. Greenspan notes, the behavior of stocks and real estate is “correlated” because both are affected by interest rates. Yet stocks have been in secular valuation appreciation for the last two decades, while residential property has been in secular valuation erosion, as discussed in Fed Focus last month.

Thus, aiming monetary policy at stocks would, in my view, be a particularly gratuitous punishment inflicted on the middle class, which has the lion’s share of its wealth in relatively “cheap” real estate. If I’ve said it once, I’ll say it again, notwithstanding the Fed’s leak to the contrary in the November 8th Wall Street Journal: If the Fed deems speculative action in stocks to be a problem, then the Fed should hike margin requirements for borrowing against stocks! The notion that it “wouldn’t work” is the skin of an excuse, stuffed with milquetoast. 

Is Your Option "In-The-Money?"

As we can all testify from personal experience, the “easiest” time to up the mortgage on our homes is when falling rates make it economical to re-finance the mortgage anyway. What’s more, re-financing is not just a matter of whether rates are up or down, but where they stand relative to the bulk of outstanding mortgages. To wit, wealth extraction from real estate via re-financing will be most powerful when a decline in rates pushes households’ re-financing option “into the money,” as vividly displayed in Figure 3. 2

nbsp;It is abundantly clear that the huge global crisis-driven plunge in mortgage rates last year facilitated a great deal of equity extraction via re-financing: For some 75% of the outstanding stock of mortgages, the re-financing option went “into the money.” It was a great time to be a homeowner, and a miserable time to be an investor in mortgages!

Currently, only about 15% of the outstanding stock of mortgages have an in-the-money re-financing option . Thus, the vast majority of  homeowners would have to “pay up” to extract equity from their home. Some will, no doubt, in part as a natural consequence of demographic-driven trade-ups (and trade-downs!), as well as the natural geographic moving about for which we Americans are famous. But the high-octane consumption fuel of rate-driven re-financings and equity extraction is yesterday’s news. Housing and consumer spending are slowing, and will continue to slow, even if the stock market continues to make the rich richer.

The Option That Most Americans
Want To Go "Into The Money"
Is The Option To Re-Finance
Figure 3
Source: Federal Reserve Bank of New York

Note: In-the-money thirty-year MBS is the percentage of existing thirty-year mortgaged-backed securities issued by government agencies (Fannie Mac, Ginnie Mae and Freddie Mac) that have interest rates at least 100 basis points above the current thirty-year contract rate.

And it might. But if it does, it will indeed be entering the “irrational exuberance” zone. While I may be a founding member of the Brave New World club, I’ve always believed that the thesis implied a higher “normalized” P/E multiple, not a perpetually-rising P/E multiple . I’ve always believed that at some point, all those wonderful things I wrote about at the outset would be “fully priced” into stock valuation.

The journey to the New World would be over, and extraordinary returns to stocks would give way to lower expected “normalized” returns on stocks, a tautological consequence of a lower equity risk premium. Indeed, I used my New Year’s Eve missive at Warburg last year to “officially” declare myself agnostic on stocks at prevailing P/Es (Yes, PIMCO readers will get a New Year’s Eve missive this year!). Since then, my agnosticism has been morphing toward a conviction that, as at Rick’s Café, there may be a little gambling going on in them there S&P pits.

Living the American Dream

But no reason for dismay. As citizens, we get to live in this wonderful economy, even if the stock market is over-discounting its wonders. And for the vast majority of Americans, who have the bulk of their wealth invested in real estate, it will no longer be necessary to apologize for doing what comes naturally: Buying into the American dream of owning one’s home. Even Mr. Greenspan seems to concur, declaring (in wonderful principled populist fashion!) last week in a speech to community bankers that:

“Lowering the costs of homeownership is particularly important for increasing home-ownership rates among young adults. Recent progress in this area has been encouraging. For example, homeownership for adults from ages 25 to 29 has risen from about one-third to about 36 percent over the past several years. But in the early 1970s, the ownership rate for this age group was 44 percent. Putting today’s youth on a higher ownership trajectory would be in the best interests of both your industry and of the country.”

Paul McCulley
Executive Vice President
November 10, 1999











1 Thanks to Joe Tracy, Federal Reserve Bank of New York, for sharing his analysis of this data. See “Are Stocks Overtaking Real Estate In Household Portfolios?” Current Issues In Economics and Finance, Federal Reserve Bank of New York, April 1999.



2 See “Mortgage Refinancing and the Concentration of Mortgage Coupons”, Current Issues in Economics and Finance, Federal Reserve Bank of New York, March 1999.


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