Using Tower Building to Predict Stock Market Returns

An interesting paper by Dr. Guenter Loffler, a Professor of Finance at University of Ulm in Germany titled "Tower Building and Stock Market Returns" draws an interesting historical connection between the construction of a large number of buildings and the behaviour of the stock market.

For his study, Dr. Loffler selected buildings that are classified as either high rise or skyscrapers and excludes buildings such as city halls, courthouses, capitol buildings and county halls since the construction of government buildings should be less sensitive to economic cycles since they may well be built during economic downturns as part of a stimulus package.  Dr. Loffler also focuses on construction starts rather than construction completions because starts better reflect the economic situation at the time.  Dr. Loffler is also selective in his definition of which buildings qualify as noted here:

"As a measure of US tower-building activity, I examine the number of towers exceeding a threshold defined by the trailing average height of large buildings. Since the height of large towers is trending upward over time, this appears superior to the use of a fixed threshold such as 100 meters. Specifically, I define the threshold to be the average height of buildings of over 50 meters that were built in the thirty-year interval before the year in question. The choice of thirty years is motivated by the observation that building activity can follow relatively long cycles. For example, in the 20 years from 1933 to 1952, only 76 towers of over 50 meters were built, and these had an average height of 80.1 meters. This compares to an average height of 88.9 meters for the 473 towers whose construction began during the 1923-1932 period. Using a trailing average of thirty years makes the threshold less dependent on general cycles in building activity, and thus better suited to identifying buildings that would be considered tall."

The variable "LargeStart" is the measure of tower building activity and is calculated using these equations:

Here is the building activity of large buildings over the past century and a half as defined by LargeStart:

Using annual stock market returns over the period from 1871 to 2010 from Robert Shiller's website, Dr. Loffler's analysis shows that construction starts for skyscrapers show significant predictive ability.  His analysis shows that high levels of tower building activity goes along with low future returns; a one standard deviation increase in tower building activity lowers three-year stock market returns by 11.8 percentage points or 3.9 percent per year.

I found the data from the 1920s particularly interesting.  Here is a list of the towers that were expected to break the height record when construction began by year:

Notice the skyscraper building boom during the late 1920s just prior to the Great Depression.  Even though construction began in 1930, one could include the Empire State Building in the pre-Depression buildings since construction was planned during the late 1920s when John Jakob Raskob and his partners purchased the Waldorf-Astoria hotel that was on the site.  While there is some correlation between construction starts for record-breaking buildings and stock market performance prior to 1945, after World War II, the relationship is not as robust as the correlation between construction starts for large buildings and stock market performance.  This means that investors should focus on the building of large towers rather than record-breaking towers to predict future stock market direction.  Dr. Loffler notes that more recently, the number of towers over 100 metres in height on which construction was started in 2007 was more than twice the annual average of similar construction starts over the period between 1987 and 2006.  We all know what happened to the stock market in 2008, don't we?  One prime example of what happens during a building/stock market boom - bust cycle is the Chicago Spire.  This tower would have become the second highest tower in the world at 2000 feet (150 stories).  The design received final approval in 2007 and construction began.  In late 2008, construction was halted after the foundation was laid, largely because the global financial crisis negatively impacted the ability of the developers to get further financing. 

Dr. Loffler suggests that there are two possible reasons for the connection between tower building and returns on the stock market:

1.) It proxies for market sentiment (i.e. potential overvaluation).

2.) It captures the credit market conditions at the time (i.e. potential over-exuberance).

This analysis shows that the over-optimism that is present in the economy during boom periods impacts both the stock market and the building of skyscrapers.  During periods when businesses and individuals are less concerned about risk, it is easier to finance large-scale construction of office towers just as it is more likely that individuals will enter the stock market and bid up share prices.

The relationship between the construction of skyscrapers and the future direction of the stock market is rather compelling.  It provides investors with an additional tool that can be used to assist in gaining a sense of where the market could be heading at a time when an increasing number of large tower construction makes the economy appear to be immune from any correction.