The Active Indexer: Escape From Normalville

December 07, 2006

Reaping higher rewards with lower risk, as the housing economy goes bust.


Wall Street downplays recent year-over-year (YOY) home price declines (Figure 1). They expect a minor pump on the road to prosperity. Negatives are expected to be temporary without the effects evident around 1991, which was the last time home prices fell (RGDP was negative).  Here is evidence that 2006-2007 may be like 1990-1991, which was the last time that we had a housing slump, slowing economy, Iraq War with bulging deficits, and a slightly inverted yield curve.

In summary, this report provides evidence that there is a high probability of the following (nothing is for sure):

(1) A housing recession has begun (fewer units are being sold below median prices, more consumers not buying). (2) The housing markets are likely to remain weak for an extended period.
(3) The economy will experience a severe earnings and/or an outright recession in 2007.
(4) The market may correct more than 20 percent in 2007 because, P/Es are dear near profit peaks (normal is hard to price).[1]
(5) The Federal Reserve is likely to ease sometime during 2007.

Figure 1 shows Oct-2006 new and existing median year over year (YOY) home price changes at 1.9 percent and -3.5 percent. New home peak-to-trough declines from Apr-2006 through Sep-2006 were -15.1 percent (largest decline on record), vs. -3.3 percent through October.  New home prices unexpected jumped to $248,500 in October. Higher prices might not be sustainable because supply rose to 7 months of inventory, 36 percent of the homes sold in Oct-2006 were more than $300K (30 percent in the prior month), and only 37 percent were less than $200K (44 percent prior). October existing home prices saw their first three-month consecutive price decline ever and are down 4.2 percent from their Jul-2006 price peak.  Supply rose to 7.4 months.

Every picture tells a different story. Extremely negative wealth effects are dependent upon the existence of weak or strong correlations between home prices and Real Gross Domestic Product (RGDP) growth and broad market indices. Before assuming that current concern about housing are unwarranted, let's investigate the housing effect upon economic growth and

stock prices through housing price trends and the Housing Market Index (HMI).[2] We also review how homeowner equity may influence the financial security and the future spending behavior of Baby Boomers.[3]

HMI results from a monthly survey conducted by The National Association of Home Builders (NAHB). They have been conducting this survey for 25 years. Builders are asked to rate their sales expectations of single-family homes. Current and future expectations (next six months) are rated "good", "fair", or "poor".  They also rate the traffic of prospective buyers as "high to very high," "average," or "low to very low." Scores to each component are used to calculate a seasonally adjusted index.  Scores over 50 indicate conditions are "good".  Readings below 50 indicate "poor" ones.

Figure 2 shows that from January 1991, stocks rallied 30.5 percent 12-months following a slump in home prices and a 19.99 HMI score. Prior to 1999, 12-month stock returns were low after HMI peaks and high after troughs, which is a negative correlation. Since 1999, correlations have been positive and RGDP has been a more dominant driver of stock returns.

Correlations tabulated in Figure 3 show that since the pop of the 2000 equity bubble, housing has become divorced from economic fundamentals. The correlation between RGDP and the HMI Index's has gone from 0.39 during the baseline period (1984 - 2006) and 0.91 from 1994 - 1999 to -0.23 since January 2000.  Meanwhile, forward or future 12-month returns for the S&P 500 Index have gone from negative -0.15 and -0.51 to a positive 0.44 correlation to housing[4].

Because housing consistently displays strong correlations to 12-month forward RGDP, it is a primary driver of economic growth.  Much like stocks, it leads other economic indicators such as consumer spending, CAPEX, and employment. For these reasons, forecasters employ housing and stocks as leading indicators.


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