Those words, uttered by President George H.W. Bush in 1992, may be coming back to haunt us today. Housing prices are falling, borrowers are defaulting, credit standards are tightening, and subprime lenders are going bankrupt. There is growing concern that the woes of the housing sector will impact the broader economy, sending it into recession. And there are numerous signals to suggest that possibility is all too real.
Perhaps the most compelling is the National Association of Home Builders' (NAHB) Housing Market Index. The seasonally-adjusted index is based on a monthly survey of builders, and has three components: current sales, the six-month forward sales outlook, and traffic of prospective home buyers. The index range is from one to 100; a reading below the midpoint of 50 indicates that more survey respondents see more poor than good conditions for home sales. The most recent reading, for March, is 36, and the index has been below 50 since last May, with the cyclical low of 30 reached in September.
The interesting thing about the NAHB Index is that, since 1996, its correlation with the S&P 500, lagged 18 months, has been a significant 83.4%. Naysayers will argue that in the 1980s, there was virtually no correlation between the two. While this is true, housing is different more recently than it was in the '80s. Then, a home was a dwelling, and those who saw it as an investment were either landlords or long-term savers, using the equity in the home to supplement traditional savings–a conservative approach.
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More recently, investment in housing has taken on the speculative frenzy of the late-'90s tech stock bubble. No-money-down real estate investing is today's version of the day-trading incubator. The average down payment made by first-time homebuyers from mid-2005 to mid-2006 was a paltry 2%. Anecdotally, a neighbor recently moved to a "hot" real estate market in Florida. He found one street where all but one house was on the market. All had been built within the last two years, and all had been listed for at least six months without a sale, and none had ever been owner-occupied. They had been purchased as new construction by investors hoping to "flip" them for a quick profit. That's what makes the current subprime debacle so risky. Subprime lenders counted on the time-honored belief that the last payment someone will default on is the one that finances their home. That may well be true. Yet what if their house is not their home, but just another speculative investment? And there's even anecdotal evidence of owner-occupied homeowners turning the keys over to their lenders, unable to meet the terms of their loans. The combination of first-time buyer, non-verified income and assets, and low credit scores has subprime lenders reeling.
The trickle-down effect is intuitive: a glut of housing stock means lower profits for builders, staff reductions by builders and lenders, and reduced consumer demand for big-ticket items. We're seeing all of those phenomena play out now. It also means lower home prices, more defaults, and a larger glut of housing stock, producing a downward spiral. If we accept the relationship between the NAHB Index and the S&P 500 since housing became the latest speculative fad, the future does not look bright. Figure 1 below illustrates the two data series plotted against each other, with the S&P lagged 18 months. While we are not forecasting a decline in the S&P to 600 over the next 18 months, the chart indicates that a sharp correction is certainly in the cards, and the underlying economic factors cited above provide fundamental support for that expectation. As further evidence, consider Figure 2 below, which provides a longer view of the performance of the NAHB Index. The red lines bracket the last two recessions, in 1990-91 and 2001. Note that the NAHB Index dropped below 50 in mid-1989, briefly corrected, then fell below 50 again in October 1989 to remain there for three years. The October decline preceded recession by nine months. While the index did not dip below 50 in advance of the 2001 recession, it did decline by a third prior to the recession, about the same magnitude decline as witnessed prior to the previous recession. The current correction has the index down 50% from the cyclical peak.
It is also intuitive that the index would have been a leading indicator of the '90-91 recession and not the 2001 version; the former was a credit-driven downturn–similar to what we face now with the subprime situation–while the latter was fueled by a stock market bubble. That the index's decline below 50 lagged the most recent recession is equally intuitive: New home purchase activity in that cycle was fueled by the wealth effect of speculative equity investment, whereas the speculative investment in this cycle is directly in real estate itself.
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