Weekly Market Pulse: The Forgotten Asset

You can’t take the same actions as everyone else and expect to outperform.

In order to outperform, by definition, you have to depart from the crowd. You have to hold a different position.

If your portfolio looks like everyone else’s, you may do well, or you may do poorly, but you can’t do different. And being different is absolutely essential if you want a chance at being superior.

Howard Marks, from his memos “Dare to Be Great II” and “I Beg To Differ”

It seems as if everything I read today is about AI, what its impact is and will be. Tech companies are investing trillions of dollars in AI infrastructure, a high risk bet – in my opinion – that demand for AI will ultimately justify these enormous investments. The companies supplying the materials for AI data centers are booking enormous profits and investors are struggling to figure out how sustainable it all is. There is robust debate about the pricing of AI and whether Chinese AI model builders are stealing from US AI labs. New models are being released almost weekly, some of which produce results that sound like a Hollywood horror movie. Analysts are confidently predicting the shape of the AI economy over the next 10 years when they don’t even know what will happen next week. It all makes for compelling reading and TV which is why all of finance media is focused on it. 

Everyone knows about the “wisdom of crowds”  and its application to markets. Or at least they think they do. The naive definition is that the collective judgment of a large group of people – a market – is more accurate than the judgment of any single expert. It is, in a way, another way of stating the efficient market hypothesis (EMH), which says the market price takes into account all the known information and is therefore always “correct”. This is the foundation of passive, index investing; if today’s market price is always right, it is futile to search for stocks that are undervalued or overvalued. But is that true? Are there no mispriced securities? Having done this for a long time I can say with great confidence that it isn’t true – there are always mispriced assets in the market.

That doesn’t mean you can identify them consistently but they for sure exist. And there are times when it is shockingly obvious that some asset class is over or undervalued. The dot com stock boom wasn’t rational. The Nifty Fifty stocks, the one decision stocks of the 1970s, were wildly overpriced. What about the stock market as a whole in 1982? The S&P 500 (SPY) had a dividend yield of 6.7% and the trailing P/E was 7. Oil at $11 in 1999. Gold at $250 in 1999 with the Bank of England selling at the low. There are plenty of other examples.

There is a crucial difference between wisdom of crowds and the EMH that most everyone who cites it forgets or, more likely never knew. There are four mandatory conditions necessary for the WOC to be right:

1. Diversity of Opinion: The group must be made up of people with different backgrounds, unique perspectives, and varied mental models. If everyone thinks exactly the same way, they share the same blind spots.

2. Independence: Individuals must make their guesses or decisions without being influenced by the people around them. If people know what others are answering, the crowd’s wisdom collapses into conformity.

3. Decentralization: People must be able to draw on their own local, specialized knowledge rather than being directed by a top-down central authority.

4. Aggregation: There must be a mathematical or mechanical way to turn all the private judgments into a single collective decision (e.g., taking an average, counting votes, or establishing a market price).

In liquid developed markets, conditions 1, 3, and 4 are always present; they’re part of the design. Condition 2 – independence – on the other hand, is not. Everyone gets the same price, the same news feeds, the same government information release, the same social media posts all at the same time. Our modern connected world is an almost ideal environment for manufacturing mispriced securities. In today’s markets, everything is taken to an extreme, everyone acting – reacting – to the exact same narrative written by…who knows? The news drives the price and the price drives the news. Sometimes it’s negative and sometimes it’s positive but there comes a point where investors lose their independence. They are heavily influenced by the commentary, by the opinions of other investors, and by the price action. They aren’t making a rational decision based on facts; they are acting solely based on the actions of others. If you want to find over or undervalued securities, read the headlines.

I don’t think we can say today that the opinions being expressed about AI are universally positive – there are still parts of the narrative that aren’t consistent – but there is no doubt that it is the dominant topic of discussion among investors. And to the degree there is negative commentary, it is mostly about the degree, how positive it will be. There is little dissent from the common narrative that it will be BIG; the question is how big. And there is no doubt that the price action is influencing people’s opinions about the stocks; they aren’t buying because they have done any investigation of the fundamentals. They just have a bad case of FOMO (fear of missing out). You could short a lot of these AI stocks today, be right about your thesis. And lose your shirt because it gets even more irrational. As John Maynard Keynes once said, the market can stay irrational longer than you can stay liquid.

For an example of the negative version, we need look no further than the commercial real estate market a few years ago. All the commentary about real estate a few years ago was negative and everyone knew the reasons:

• Interest rates and the maturity wall: All those low rate loans taken out when rates were near zero were coming due and owners would have to refinance at higher rates.

• At the same time, operating costs were rising due to inflation; net operating income (NOI) was getting crushed.

• The regional bank crisis that arose due to the failure of Silicon Valley Bank and several others meant that regional banks, which do much of the lending in commercial real estate, wouldn’t have the ability to lend and refinance real estate loans.

• Regional banks were faced with losing uninsured deposits to Tbill and money market funds further limiting their ability to lend.

• Property insurance rates soared in some of the major growth markets (Florida in particular)

• Work from home meant that office buildings would never rebuild occupancy rates.

• With transaction volume low, it was hard to value buildings which made transaction volume fall even further

• Rising interest rates put upward pressure on cap rates; prices fell and were widely expected to keep falling

To put it bluntly, no one wanted anything to do with commercial real estate, especially after Silicon Valley Bank failed in the spring of 2023. Publicly traded commercial real estate – REITs – fell dramatically through 2022 and 2023. REIT prices were being driven almost exclusively by rising interest rates, which made all those problems above worse. REITs finally made an initial bottom in October of 2022, down almost 33%, when the 10-year rate hit 4.33% but they recovered as interest rates fell back, rising almost 25% by February of 2023. But once rates started rising again, REITs went into freefall and made a new low when 10-year Treasury rates peaked at almost 5% in October of 2023. That proved to be the point of maximum pessimism – and no one noticed. 

Since that bottom, REITs have returned over 58% or 18% annualized. That isn’t as good as the S&P 500 since then, which put up annualized returns of almost 25%, but it is a great return. And over the last year, REIT returns are almost the same as the S&P 500, despite the broader stock measure being dominated by the AI phenomenon. And this year, REITs are outperforming both the S&P 500 and the NASDAQ 100 (QQQ), up over 16% while the S&P is up 9% and the NASDAQ is up 11.6%. And while I have seen some articles about it, it certainly isn’t well known.

What is perhaps more interesting is that REIT returns appear to no longer be captive to interest rates. REITs have been rising since late March even as interest rates have continued to rise. That doesn’t mean rates haven’t had any impact – REITs fell in most of March as rates rose – but the impact has been more muted. Something similar happened back in the 1970s. REITs were down with stocks in the bear market of 1973/74 when rates were rising, but that was more about the recession that accompanied it than the rates. After the recession ended, rates kept rising but REITs did too; REIT returns averaged 26%/year through the rest of the decade. In fact, that period of high inflation and high interest rates was one of the best runs for REITs in their history, up 12 years in a row from 1975 to 1986. 

REITs are sensitive to interest rates but they are also sensitive to inflation and we may have reached a similar inflection point. Real estate is sheltered from inflation by rising rents and at some point the rising rents mean more than the higher interest rates. Is this that point? I really don’t know but I am pretty sure that this inflation issue hasn’t been solved. Both the 90-day T-bill rate and the 2-year Treasury note rate are above the Fed Funds rate, a condition that has resulted in a rate hike about 80% of the time in the past. And if we get one rate hike, the odds of another are almost certain. The market certainly believes that interest rates are going higher and while the economy is doing okay, it isn’t real growth that is driving NGDP and rates higher.

REITs are part of the strategic allocation for our client portfolios – we always own REITs. We do because they have historically produced returns that are similar to stocks but not at the same time – the correlation between REITs and stocks is about 0.5, enough that they often share the same general direction, but independent enough to provide meaningful portfolio diversification. The NAREIT All Equity REIT index starts in 1972 and through 2025, the compound annual return was 10.8% vs 11.2% for the S&P 500. More importantly, REITs outperformed in the two periods when stocks performed particularly poorly. From 1972 through the rest of that decade REITs returned 11.1%/year while the S&P 500 returned 5.03%. For the decade starting in 2000, REITs returned 10.63%/year while the S&P 500 returned -1%/year. In fact, REITs have provided double digit returns in every decade since their inception except the 1990s, when they managed only 9.14%/year. They won’t necessarily save you from a big downdraft – they fell more than stocks in the 1973/74 bear market and in 2007/8 as well – but they do tend to perform well when stocks don’t for an extended period of time.

Crowds are not always wise. Sometimes they are irrational herds, with everyone doing the same thing because everyone else is doing the same thing. It works in both directions, the crowd sometimes overly optimistic and sometimes overly pessimistic. Long-term investors can take advantage of these manic episodes through tactical, opportunistic rebalancing. That’s what a strategic allocation – a long-term distribution of your capital across a defined set of asset classes – allows you to do. When one of the assets in your strategic allocation has produced above average returns, your allocation to that asset will rise above your target. When some other asset has produced below average returns, the allocation will fall below your target. Rebalancing merely forces you to buy low and sell high. As for defining too optimistic and too pessimistic, all I can say is that it is in the eye of the beholder. And the older your eye the more likely you are to get it right; investing is a game that is only truly learned through experience. 

REITs have produced annual returns well below average so far this decade (5.1% vs 10.8%) while stocks have run well above average (15.2% vs 11.2%). The fundamentals for REITs are favorable with new supply constrained by higher interest rates, balance sheets in great shape (leverage ratio is about 35%), rents and funds from operations are rising (FFO +14.8% in 2025), work-from-home is dying a slow but steady death, dividend yields are well above the S&P at about 3.7% and rising (up 6.36% last year), occupancy rates at 93.2% are historically strong, and a lot of REITs are trading at less than NAV (net asset value). 

This is the opportunity the market is offering right now. Stocks are highly priced and prized, REITs are cheap and unloved. I have no idea whether AI will revolutionize the world or just be a giant waste of investment. But no matter what happens with it, we’re going to need apartments, and shopping centers and office buildings and warehouses and probably even data centers. I’m not saying you should sell all your stocks and buy real estate instead but selling some of the former to buy some of the latter is just good portfolio management. And it’s different, the essential element for outperformance.