Can Wall Street withstand weak housing?

ANALYSIS

By Peter Coy

updated 4:28 p.m. ET Sept. 19, 2006

If your nest egg is made of 2-by-4s and you're watching the real estate slowdown with a mixture of fear and nausea, then this article is for you.

The question: If real estate tanks, will stocks follow? Or will the market ignore housing? Or maybe — just maybe — will a decline in housing trigger a rise in stocks? It's something you really ought to think about if you're trying to figure out where to put your money.

Conventional wisdom, and some historical evidence, suggests that a decline in housing is associated with a fall in stocks. Evidence of a slump continues to mount: On Sept. 18, the National Association of Home Builders said its monthly sentiment index fell to a 15-year low. And on Sept. 19, the Commerce Dept. said that housing construction fell 6 percent in August to its lowest level in three years — an annual rate of 1.67 million starts.

"If that's not meltdown, it's pretty close," Ian Shepherdson, chief U.S. economist of High-Frequency Economics, said in a research note. The prospect of stocks plummeting at the same time housing falls into a slump is bad for homeowners, because it means no port in the storm. But the case isn't completely closed: There's some tantalizing counter-evidence that stocks might do just fine in a housing downturn, or even benefit from it.

Time lag
Let's start with the main, bearish case. Making the rounds of investment advisers is a chart prepared by Merrill Lynch showing the Standard & Poor's 500 stock index overlaid on an index of homebuilding activity from the National Assn. of Home Builders. The chart shows that the S&P 500 goes up one year after the homebuilding index goes up, and goes down one year after the homebuilding index goes down. (The correlation is 0.8, which means it's pretty strong.)

The scary part: The homebuilding index has plunged over the past year. If you believe that history repeats itself, the S&P 500 is about ready for a nosedive.

Another chart — this one from InvesTech Research — correlates changes in private residential construction with recessions. Going back to 1968, it shows that with just one exception, every time there has been a downturn in residential construction, a recession has occurred at the same time or shortly after. (The exception: 1995.) That indicator, too, is flashing red, because residential construction has shrunk over the past year.

"Being a student of history, I would think I would want to play it very cautiously from a stock standpoint," says Standard & Poor's Chief Investment Strategist Sam Stovall.

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Wealth effect
It makes some sense that a housing slump would be bad for stocks. First, there's the direct effect on jobs in construction, real estate brokering, mortgage lending, and so on. Goldman Sachs estimates that housing and related industries account for nearly 10 million jobs (payroll and nonpayroll combined).

Second, consumer spending has been buoyed by the housing boom. People spent more freely because they felt wealthier and because they turned their homes into piggy banks through home equity loans, cash-out refinancing, and other means. Take away jobs and consumer spending, and it's no wonder that many experts expect a housing slump to hurt stocks.

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