I’m going to try to take the cap rate discussion a different direction in this post. I really like all of the thoughtful comments that people are making and I think this is a good discussion to have.
The graph below was prepared to take a look at what technical indicators market data might give off, if any.
The blue line on the graph below represents the same cap rate to 10 year UST spread that we’ve been talking about for a few days now. But I’ve also added a trailing four quarter moving average.
In my mind, the important question is whether moves above or below the moving average tell us anything important about the future of the market. In the stock market, moves above the MA or below it are usually pretty important technical events.
So through an admittedly small number of observations we can say that if we believe in technical indicators, the market was giving off the following signals:
- Q2-03 spread moves aggressively below the 4QMA. Market signal = Buy.
- Q3-06 spread moves slightly above the 4QMA for two quarters, then goes lower again for two quarters, then moves aggressively above the MA. Market signal = Sell. This one really requires the benefit of hindsight because the spread is above and below the 4QMA for a few quarters. But had you used the Q3-06 movement above the trend as your sell signal, you would have saved yourself a lot of heartache when the market started to seize up during the credit crisis.
- Q1-10 spread is very close to the 4QMA. Market signal = Pay attention to moves above or below the line. Trend isn’t aggressive in either direction.
The interesting thing about the ideas that I am putting forward is that they really don’t have enough empirical testing to be relied upon. I don’t have the data that would be needed to go further back in time to test any thoughts I might have. But the reason that I throw these ideas out there is that I believe that something like this should work.
I do not believe in the notion that anything has any real inherent value that would allow you to say that something is overvalued or undervalued based on historical standards like a long term average. Investors change their minds over time. Tax rules change. The regulatory environment changes.
What I do have faith in is the tendency of investors to swing wildly between a buying mentality and a selling mentality. So how do you figure out which way the herd is going to go, and how do you get there first? I guess my thesis is that there is no need to view long term trends. Look at the four quarter trailing trend. When the data point moves aggressively above or below that trendline, evaluate your portfolio strategy.
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