Will the Economy be Affected by a Housing Recession?

There’s been a lot of talk over the past couple of months that a recession in housing will not affect the entire economy. The growth of the service sector has made GDP growth rely less on manufacturing, and thus less prone to being affected by a downturn in those sectors.

I can’t say I agree with this. Below is a chart that tracks the Housing Market Index and the S&P500 on a twelve month lag from January 1995 to February 2007. Although I wasn’t able to find out what the exact correlation between the two numbers are, I have also included a scatter diagram, which shows there is a pretty strong positive correlation between the two numbers.

Furthermore, I don’t think the rebound in the HMI will be sustained. With the subprime crisis that is currently developing, and the tightening of lending standards, there will be further weakness in the HMI number in the coming months.

What I find even more interesting besides the correlation that has been evident for the past 12 years, is that in the period from 1985 to 1995, this correlation was non-existent. Although I don’t know exactly what the explanation to this phenomenon is, I’m hoping that someone can shed some light onto the reason that the economy is more closely tied to housing now than in the past. Especially when the increase of the service sector was supposed to eliminate the effects of a slow down in housing.