Madam, I did not mean to throw down a gauntlet down before someone I hold in such high esteem…however, since we find ourselves in a position of misunderstanding, please allow me to elaborate: I speak not of bubbles per se, but examples of overreliance of the reversion of the mean for future predictions, specifically with predictions of how long the system will take to revert to the mean, and especially on how to measure the mean (the chosen time frame, statistical methods and ways of grouping the data can materially affect one’s conclusions, for example). There is no objective way to do this process; honing one’s judgement in how to treat the data meaningfully is no less of an art than pre-meds spending much of their residencies examining perfectly healthy patients — they do this to calibrate their sensibility on what “the average healthy person” *is*, and is likely to be *in the future*.

I do not take issue broadly with any of your examples, or the analysis Rich or you have done to demonstrate that the recent housing market is vastly overpriced. I am however concerned that in the strong conclusions that I am hearing, there may be a lack of appreciation in how significant the difference of the sample mean might be from the population mean (ie how representative is your sample set in terms of describing the behaviour of the *whole* system, past and present), and also the difference between descriptive statistics (dissecting data from a specific sample set) and inferential statistics (projecting the analysis of your sample set onto a population, which is intimately related to my first point).

Since I started with _Against the Gods_ (mine is from 1996), I will continue from there…searching the index, “Regression to the Mean, overreliance, illustrations of”…ah, pages 182-183.

I’ll refer to the second of Mr Bernstein’s examples below (I hope my paraphrasing falls under “fair use” — but just to be sure, I encourage everyone to rush out to the public library, read through this book once for free and determine if it is worthy of a permanent place in your personal library):

Quote (p183-185, all words in [] are mine):

“Up to the late 1950s, investors had received a higher income from owning stocks than from owning bonds. Every time yields got close, the dividend yield on common stocks moved back up over the bond yield. Stock prices fell, so that a dollar invested in stocks brought more income than it had brought previously. That seemed as it should be. After all, stocks are riskier than bonds. Bonds are contracts…if borrowers default on a contract, they end up in bankruptcy, their credit ruined and their assets under the control of the creditors. With stocks, however, the shareholders’ claim on the company’s assets has no substance until after the company’s creditors have been satisfied. Stocks are perpetuities: they have no terminal date on which the assets of the companies must be distributed to the owners…the company has no obligation ever to pay dividends to the stockholders. Total dividends paid by publicly held companies were cut on nineteen occasions between 1871 and 1929; they were slashed >50% from 1929-1933 and ~40% in 1938. So it is no wonder that investors bought stocks only when they yielded a higher income than bonds. And no wonder that stock prices fell every time the income from stocks came close to the income from bonds.

Until 1959, that is. At that point, stock prices were soaring and bond prices were falling. This meant that the ratio of bond interest to bond prices was shooting up and the ratio of stock dividends to stock prices was declining. The old relationship between bonds and stocks vanished, opening up a gap so huge that ultimately bonds were yielding more than stocks by an even greater margin than when stocks had yielded more than bonds. [Discussion of how inflation underwent a serious inflection point around 1940: cost-of-living had risen an average of only 0.2% a year from 1800-1940 (140 years!!)] Under such conditions, owning assets valued at a fixed number of dollars was a delight; owning assets with no fixed dollar value was highly risky.

But from 1941-1959, inflation averaged 4.0% a year…The relentlessly rising price level transformed bonds from a financial instrument that had appreared inviolate into an extremely risky investment. By 1959, the price of the 2.5% bonds the Treasury had issued in 1945 had fallen from $1,000 to $820 [which] bought only half as much as in 1949!

Meanwhile, stock dividends took off on a rapid climb, tripling between 1945 and 1959…No longer did investors perceive stocks as a risky asset whose price and income moved unpredictably. The price paid for today’s dividend appeared increasingly irrelevant. What mattered was the rising stream of dividends that the future would bring. Over time, those dividends could be expected to exceed the interest payments from bonds, with a commensurate rise in the capital value of stocks. The smart move [at that point] was to buy stocks at a premium because of the opportunities for growth and inflation hedging they provided, and to pass up bonds with their fixed dollar yield.

Although the contours of this new world were visible well before 1959, the old relationships in the capital markets tended to persiste as long as people with memories of the old days continued to be the main investors. For example, [Bernstein’s] partners, veterans of the Great Crash, kept assuring me that the seeming trend was nothing but an abberation. They promised me that matters would revert to normal in just a few months, that stock prices would fall and bond prices would rally. [As of 1996], I am still waiting…”

***

So from this example we see how the noise of WWII hid the disequilibrium shift in inflation, which became the main factor in answering the question “should I buy stocks or bonds?” If we were to judge our mean based on 1800-1940, we would conclude one way; if we were to judge after WWII, we would conclude the opposite on a much smaller data set. The winds really had shifted for the foreseeable future.

I am not making any sort of prediction, with regards to housing, the economy or anything else. What I am doing, is pointing out that something as hugely distorting as the recent run-up in prices, largely due to irrational exuberance, may very well have also hidden more subtle yet persistent factors that could very well change the dynamics of the outcome. If sentiment is the kinetics of the system, then factors like monetary policy, inflation targets, the strategic importance of San Diego (militarily or economically to the country, affecting what kinds of incentives are created by private groups or the government for people to live here) that cannot be captured with a headline or a soundbite are the thermodynamics. And I am interested in characterizing each of these appropriately.

But your posts are highly educational, “I enjoy our visits” 😉