Vanguard’s Brennan on Stock Market: Resist Temptation; Emphasize Diversification; Stay Calm

As every iron-bellied investor these days knows, U.S. stock markets have been going through a highly volatile period. Hardly a week goes by when the Dow and the Nasdaq indices are not swinging sharply—either up or down. What accounts for this volatility? What is a sensible investment strategy for executives who do not want to be blindsided? John J. Brennan, CEO of The Vanguard Group, the second largest mutual fund company in the U.S.—managing assets worth more than $500 billion—has some thoughts about that.

Brennan, who spoke at a meeting of the Samuel Zell and Robert Lurie Real Estate Center in Philadelphia last month, said that in the first quarter of this year, volatility has been extremely high, by historical standards. While stock market returns have been exceptional, he sees three important trends to which investors should pay attention.

First, the strong returns have been produced by a narrow band of stocks, particularly those of technology companies. Second, some stock valuations appear to be high. For example, historically, price-earnings ratios based on forward earnings have been between 12 and 20. In March, however, the p-e ratio of stocks in the Nasdaq 100 index was 108. This reflects tremendous bullishness among investors about the future, according to Brennan. Third, the ratio of margin debt to household income has reached very high levels. All these factors combine to add an enormous level of risk to the stock market. The rise of so-called momentum investing—in which investors find out what’s hot and join the party—further adds to the risk.

What, then, should investors be doing? Brennan said that investors should not forget the lessons of the past. His advice was to resist short-term temptation when investing in stocks. Secondly, he urged diversification, which guards investors against their own ignorance. Third, he recommended that investors have a plan—and that they stay calm.

In addition to the state of the stock market, several other issues came up for discussion at the meeting. Among them: Trends in public and private real estate capital markets, new revenue-generating opportunities in real estate, and the future of real estate.

Joseph Gyourko, director of the Zell-Lurie real estate center, moderated the discussion about trends in the capital markets. The participants included Richard Adler, managing director of European Investors; Jeffrey M. Kaplan, president of Cohen & Steers Capital Partners; Matthew Lustig, managing director of Lazard Freres; and Bernard Winograd, CEO of Prudential Real Estate Investors.

The participants discussed the reasons why investors appear to have lost their appetite for large-scale, complex deals. "The past year and a half has been unusual," said Winograd. "We have been in an extended period where cap rates have been moving up, and demand and supply have been roughly in balance. Most institutional investors see this as an equilibrium condition. And we aren’t used to being in equilibrium; we are used to riding a cycle." Other panelists pointed out that while investors are increasingly unwilling to take equity risks, the transaction volume, too, has declined. Several real estate investors are targeting property types such as apartments and industrial real estate, which are likely to outperform the market in a future downturn.

Another session focused on new opportunities—including the Internet—that real estate companies could pursue to generate revenue streams. Moderated by Asuka Nakahara, associate director of the Zell-Lurie Center, the panel for this session included Julie Benezet, director of global real estate and facilities at Amazon.com; Dale Anne Reiss, global industry leader of real estate at E&Y Kenneth Leventhal; Julien J. Studley, CEO of Julien J. Studley, Inc.; Richard L. Michaux, CEO of AvalonBay Communities, and Randall Von Feldt, managing director of operations in the Dallas office of Scient.

Benezet provided a fascinating glimpse into the way dot-com companies, whose business models have more to do with clicks than bricks, operate in the real estate business. For all its furious activity in cyberspace, Amazon.com did 26 real-estate deals last year and built 6.5 million sq. ft. of real space, including offices, warehouses, and call centers. Since dot-com companies tend to grow rapidly through acquisition, they like dealing with real estate providers who are flexible. "Landlords who prevail with us have the ability to add more space," Benezet said.

Studley agreed. He pointed out that three things make dealing with dot-com clients different: They move fast, they have small staffs, and they share decision-making. "We got a new client from this industry, and they first wanted to meet our technical people, not our deal people," Studley said. "This is not the way we did business. Our older clients can learn a lot from them." The increasing importance of the Internet is forcing more real estate executives to take it seriously. Michaux said he now spends 60% of his time on "the convergence of the Internet with real estate."

Has the coming of the Internet created an environment where the old adage "location, location, location" is no longer relevant? The panelists did not think so. On the contrary, urban centers have benefited from the dot-com revolution, primarily because cities provide housing, retail and entertainment—all conveniently located together. Cities such as Seattle and San Francisco have gone through major changes and improvements. "The suburbs destroyed the cities, but the Internet is bringing them back," said Studley.

In addition to the Internet, globalization is transforming real estate. Thomas Friedman, New York Times columnist and author of such books as The Lexus and the Olive Tree and From Beirut to Jerusalem, discussed the forces that are drawing national economies into the global market. "Globalization is not a trend or a fad," he said. "It is the system that has replaced the Cold War system. Globalization will affect every country, company and community." Explaining the difference between the Cold War system and globalization, Friedman pointed out that while the former was based on division, the latter is based on integration. "The Cold War system was built on weight; globalization is built on speed," he said.

Globalization is the result of the democratization of finance, technology, and information, according to Friedman. "These three factors converged into a whirlwind at the end of the 1980s," he said. "The information revolution created cyberspace." And when walls—political and economic—began to fall, it opened up new opportunities as well as threats. "When the walls fall, we are all in each other’s business," Friedman noted.

The final session brought together three experts—Michael D. Fascitelli, president of Vornado Realty Trust, Michael J. G. Topham, executive vice president of Hines, and Samuel Zell, chairman of Equity Group Investments. They peered into a crystal ball to look toward the future of real estate over the next five years. Today, many youngsters view real estate as a plodding, old economy industry that lacks the sex appeal of the dot-com world. Still, for those who have the vision and the energy, real estate provides—and will continue to provide—incredible opportunities. "Real estate is a giant industry," said Zell. "Two years from now, we’ll look back at the dot-com mania and see the replication of what happened to real estate during the 1980s. It was an industry destroyed by over-allocation of capital. We are witnessing a massive distortion of the economy, and it’s going to be very expensive."

The panelists also saw another major change emerging over the next five years. Oligopolies are coming into existence. Five years from now, the real estate industry will be divided between "creators of product and operators of product," though there may also be companies that do both. As one panelist noted: "We will have to adjust the way we operate and think."

 

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