Housing Weakness Poses a Significant Threat to GDP and Stocks

Chris Ciovacco submits: As shown by the National Association of Homebuilders [NAHB] Homebuilders Index (see blue line in chart below), the slowdown in housing has now reached significant levels. NAHB produces the Housing Market Index [HMI], a weighted, seasonally adjusted statistic derived from ratings for present single-family sales, single-family sales in the next six months, and buyer traffic.

A rating of 50 indicates that the number of positive or good responses received from the builders is about the same as the number of negative or poor responses. Currently, the weighted rating is firmly in the negative camp at 32. This represents a pessimistic outlook for real estate in the next six months, which in turn is not good for stocks. The chart was taken from a report by David Rosenberg, North American economist for Merrill Lynch. Mr. Rosenberg comments on how the weak housing market may affect stocks:

The chart above is rather intriguing - the NAHB homebuilders index leads the S&P 500 by 12 months and with a near-80% correlation - a correlation that over time has actually strengthened, owing to the growing influence that the real estate market has exerted on the overall economic and financial landscape over the past five years. In fact, we can trace almost two-percentage points of the 3 1/2% average annual rate in real GDP over that time frame to the boom in housing construction and home prices - the direct impact on homebuilding, the spin-offs to other sectors like real estate services, architecture, engineering, legal, etc and the multiplier impact from the 'wealth effect' on consumer spending, especially on home improvements and household furnishings.

The statement above means that during the past five years housing has either directly or indirectly accounted for 57% of economic activity. The latest release of new home sales shows a 21% year-over-year decline.

Using the 12-month lag of the S&P 500 (SPY) as shown in the chart above, the actual correlation between the S&P 500 and the homebuilders index is .79, which would give us the following calculation to forecast where the S&P 500 may be 12 months from now (roughly August 31, 2007):

* The homebuilders index had a reading of 67 in August of 2005 (12 months ago)

* The reading of the index as of August 2006 is 32

* A move from 67 to 32 represents a 52% decline

* With a .79 correlation to the S&P 500, we need to reduce that decline by 79%, which gives us roughly 41% (reduced from 52%)

* If the correlation holds, which it may not, the S&P 500 would be 41% lower 12 months from now (or roughly on August 31, 2007).

That is a sobering stat. While I am not forecasting that the S&P 500 will be 41% lower a year from now, I am in the camp that believes it is prudent to take a more defensive posture with our investment portfolios. This is a correlation that cannot be ignored by investors.

It is also interesting to note that the last intermediate peak in the homebuilders index was made in October of 2005. This means according to the 12-month lagging correlation the S&P 500 would hit an intermediate peak sometime in or near October of 2006. As the chart below illustrates, most recessions have been preceded by a period where housing prices decline (prices shown are adjusted for inflation - recessions are shown by shaded areas).

The Recent Advance In Stocks Is Suspect
While the recent advance in stocks is somewhat impressive, the statistics below the surface paint a picture which warrants concern about the sustainability of the rally. We have not seen figures in volume, new highs vs. new lows, common stocks vs. preferred stocks, etc., that produce a favorable risk/reward profile for taking substantial risk in the general stock market at the present time. Dr. John Hussman covers this topic in more detail in his article "A House Built On Sand", which contains the two informative charts below (my comments have been added to charts):

[click to enlarge]

The U.S. stock market has gone over three years without a 10% correction. This has happened only three other times in modern market history. The average decline after the previous three runs was over 18%.

It Will Be Hard For The Fed To Bail Out The Housing Market
We are all hoping for the proverbial soft landing in housing, which in turn would enable a soft landing to take place in the economy as measured by GDP (the value of all good and services produced in the U.S.). If we use the boom in Internet stocks as a proxy, it is difficult to assume we will get the soft landing in housing.

The chart below, taken from an August 2005 article in Forbes magazine, shows the Internet boom and the housing boom side by side. Fueled by low interest rates and thus cheap access to credit, the similarity between the two booms is striking.

Once the Internet bubble started to burst, the Federal Reserve tried to engineer a soft landing by cutting interest rates 11 times in just 12 months, moves which are still without precedent today. Despite this aggressive action, we all know that the proverbial soft landing did not occur in the Internet space. The bond market's recent gains in price are signaling that the Fed may be lowering rates in the future in an attempt to slow the tide of the housing decline.

The media and Wall Street are always hoping for the soft landing or "Goldilocks" economic scenario. Unfortunately, the odds are stacked against having a soft landing after a series of interest rate hikes. During the last 16 interest rate cycles, there has been a grand total of one soft landing (see 1994). Using this one historical fact, there is a 6.25% (1/16th) probability that we get a soft landing. With these odds, is it worth taking on too much risk with your hard-earned investment dollars?

The Economic Impact Of The Housing Boom
Economic gains in the United States in recent years have relied heavily on the rapid appreciation in the housing sector. According to a report on housing from Scotiac Capital:

Consumer spending on furniture and household equipment has grown at more than 3½ times the pace of the overall economy during the current expansion, accounting for a 14% share of overall growth (nearly three times its share of the economy). Growth in residential investment has been double that of the overall economy during the same period, accounting for 10% of overall growth (compared with a 5% share if the economy). Finally, the construction, home improvement, and real-estate related sectors accounted for nearly 20% of overall private sector job creation in 2004 and 2005, double their share of private sector employment. Considering the amount of housing-related stimulus the economy has enjoyed in recent years, we expect a noticeable deceleration in the pace of real GDP growth over the forecast period – from the +3½ average of the past three years to something closer to +2½.

Forbes makes an argument that the overall economic impact of the recent housing boom is greater than the largest ever stock-related booms:

The total value of residential property in developed countries has increased from $40 trillion to $70 trillion over the past five years (8.2000 to 8.2005), which (as The Economist points out) represents a larger potential bubble in terms of equivalent gross domestic product than either of the stock market bubbles of 2000 or 1929.

Conclusion
In summary, the correlation between a weakening housing market and the stock market suggests that a defensive investment stance is prudent at the present time. While the recent advance in stocks is impressive on the surface, a more detailed look yields some cause for skepticism.

History tells us that the probability of the Federal Reserve being able to engineer a soft landing in the housing market is very low. The economic impact of the recent housing boom has been greater than even the largest stock market booms. It will be difficult, if not nearly impossible, to replace this economic activity from another sector of the economy.

Comments

[Daniel Houston:]

Your correlation chart has some problems. Please post the correlation of the NAHB index and the SP for the 10 years prior to the study. You may find that the correlation relationship is actually 0 to inverse from 1985-1995. In my opinion, this is a huge bias problem in your collection of data, because we only see the data that fits.

2006 Sep 21 01:21 AM

[John Wang:]

While I agree that the housing bubble is on the verge of collapsing, I will disagree with the hard landing aspects or the comparison between the dot com bubble and the real estate bubble.

The dot com bubble was built on virtual estates, while the housing bubble is built on real-estates which have values. The values of these estates will not be reduced to nothing as in the case of the dot com estates. While the dot com bubble did crash, and there were no buying market to create that soft landing, the real-estate market is totally different. As prices drop, there will be buyers.

Just my $.02.

2006 Sep 22 04:47 PM

[Daniel Houston:]

John Wang, your comments represent a very hollow analysis, in my opinion, primarily because you're focusing on assets and not equity. Wealth created by credit can very easily go to zero even if the asset that was purchased on credit does not.

Who cares about the value of the estates? It's the value of homeowner's equity that matters, my friend - and this figure has already gone to zero for many a buyer in 2005 and early 2006 (perhaps most buyers, in fact because down payments on housing have been so tiny recently). So a huge number of investors in the proverbial dot-condos have in fact lost their virtual wealth, same as the investors in dotcom stocks before them. Their investment has gone to pot.


I wrote this on another blog and it may clarify things:

"For one, a fallout from a housing speculation bust is not the same animal as the fallout from the dotcom speculation bust. The difference is debt. It looms around for consumers after a housing bust, but not after a stock bust. Yes there were margin calls when the Nasdaq crashed - but for most individuals, even those aggressively invested in technology shares - their financial obligations did not persist beyond the original capital they invested. Their 401k's and IRAs may get hammered, but that's about it. This is not true of the money that has recently flowed into housing. "


Additionally the comment, "as prices drop, there will be buyers" doesn't truly support your argument because it lacks a timeframe. Yes at some point there will be buyers, but when? If they don't come in before a hard landing then it's tough luck. And there are plenty of instances in plenty of markets that say at times buyers don't return quickly enough.

2006 Sep 23 04:04 AM

[John Wang:]

Daniel, while my analysis may be hollowed, but it's based on substance. I do agree that a lot of people are riding on debts, and that's their own fault for not intelligently invested in the housing market at the right time. But, unlike the stock market where shares were giving away for free and nobody would want, houses on the other hand already have buyers waiting for the opportune timing.

I am one of those buyer that's sitting on the sideline waiting, and I'm sure there are more like me. My thinking is more along the line of Mr. DeLay, just not as eloquently presented. I thought I could just point out the obvious and most people should be able to correlate.

2006 Sep 25 12:32 PM

[Daniel DeLay:]

I tend to agree with the soft landing scenario for the following reasons. First as oil prices fall inflation will subside. In fact if they continue to fall through next summer we will be looking at negative overall inflation due to the comps. It may appear to be deflation, but not really. As the inflation situation tames so will the FED with the rates and once they begin lowering rates and the market will recover. Next, everyone acts as though housing has gone in the toilet, not true, this is the third best year for housing in the history of the country. I will agree growth rates have fallen sharply, however, we are already seeing the steps being implemented by major builders to allow the excess homes to be bought up. I would also argue that, in the event, their is a trend of rising defaults, as you are suggesting, the group of 12 fed banks will recognize this and drop rates based on that alone. This is not a new situation, the housing market is cyclical, in this case we are a somewhat overbuilt more so than in the past so it will take a bit longer to work through existing inventories. Buyers are sitting on the sidelines waiting for the best deal out there, rates to drop, etc. When the market does find it's bottom all the buyers will step in at once and another housing boom will begin. Its not a matter of if housing demand will come back, it is more of matter of when demand will return. My opinion is, demand will jump before this time next year. But then again, I am not like the analyst that know all and can predict the future, I can honestly say I am just guessing.

2006 Sep 23 05:39 PM