Housing Weakness Poses a Significant Threat to GDP and Stocks

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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 (NYSEARCA: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.

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.

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