What Building Towers Say About Future Stock Returns

Behavioral finance is a fascinating field, providing us with many insights into investor behaviors that help explain many of the anomalies that financial theory cannot explain on its own. It also helps explain many of the mistakes investors make. Among the most common of errors is overconfidence. Even concerns over status can lead to suboptimal investment decisions. For example, given the persistently poor results of hedge funds, the desire to be a member of an exclusive club could explain investments in these vehicles.

Gunther Loffler, author of “Tower Building and Stock Market Returns,” hypothesized that the construction of towers (large scale projects such as the World Trade Center) could provide insights into stock returns. The premise is that tower building could be a reflection of periods in which over-optimism has led to overvalued stock markets, or it helps to identify times of low risk aversion — low risk aversion leads to low risk premiums and the funding costs for large-scale projects are lower. Low risk premiums predict low future stock returns. And, of course, status could play a role in the building of towers. While Loffler doesn’t mention it, the Empire State Building, the construction of which began just as we were entering the Great Depression, could have been the poster child for the story.

Loffler tested these hypotheses by examining whether tower building was associated with lower future stock returns. Building activity is measured through construction starts of towers that exceed a trailing 30-year mean tower height. The choice of 30 years was based on the long cycles of building projects.

As an example illustrative of both interpretations, Loffler offers the Chicago Spire, which had a planned height of 609 meters or 2,000 feet. Construction of the Chicago Spire began in June 2007, a time in which credit spreads were low and valuations were relatively high. He also noted that the Chicago Spire was representative of the many high-rise buildings planned that year — the number of towers taller than 100 meters on which construction began was more than twice the annual average of such construction starts over the prior 20 years. (Note, in 2008, facing the effects of a declining economy, the Spire tower project had to be suspended. The project was officially cancelled in December of 2010.)

Data on towers was obtained from the research database of Emporis, a private information provider. Loffler included buildings that were started to be built but were never finished, thereby avoiding a possible selection bias that might arise if only finished buildings were studied. He also only considered private (non-government) buildings as government building activity should be less sensitive to market conditions, and may even be countercyclical if governments invest in buildings to smooth business cycles. He organized the data based on start of construction. The starting point for the data was 1871. The following is a summary of his conclusions:

• In the US, the predictive power of this measure compares favorably to the predictive power of the dividend-to-price ratio, as well as other variables (such as the price-to-earnings ratio) that have been studied extensively in the literature.
• High tower building activity goes along with low future returns. And the results are both statistically significant at the 5 percent level and economically significant as well — a one standard deviation increase in tower building activity lowers three-year returns by almost 4 percent per year.
• International tower building activity predicts a world ex-U.S. stock market index.
• Both credit market conditions and sentiment variables explain construction starts of large towers. Tower building activity is higher after periods of high loan growth, low credit spreads, and high investor sentiment.

The bottom line is that as surprising as it may seem, private tower building activity has provided us with information on future stock returns. And there are logical explanations for the findings (wide spread over-optimism, easy credit conditions, and low risk premiums). While I wouldn’t recommend using this indicator as a means to time the market, it might serve a useful purpose by acting as a check on your own optimism about future stock returns — preventing you from getting caught up in the herd and falling prey to the “this time it’s different” mentality that can infect investors.

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