Stocks and Real Estate

The Fed, finally, at its August 8/06 FMOC meeting, gave in to the long held wishes of investors and decided to take a break from the two-year-long string of rate hikes. The reaction to this much- awaited moment has, so far, been relatively restrained, with the market gaining about 2% since August 8th. The NYSE upside/downside trading volume ratio did not hit the extremes seen in the four months preceding August 8th, when there were huge one-day rallies on speculation that the Fed was done hiking rates.

 This lack of upside volume has been in part caused by seasonally reduced trading activity during the summer holiday season. I also suspect that there has not been any massive bidding up of stock prices because of concerns that the anticipated soft landing of the economy may just be wishful thinking.

 There are definitely enough reasons why the optimistic scenario of a Goldilocks economy may be ruined by unruly bears failing to go along. The most alarming warning signal is none other than the hissing sound of hot air from a deflating housing sector bubble, the sector of the U.S. economy credited with making a sizeable contribution to its growth and employment levels in the last four years. Rising mortgage rates, the growing resistance on the part of homebuyers to pay absurd housing prices in many parts of the U.S., and the oversupply of houses built by home builders caught in the euphoria of housing bubble, are all part of the toxic mix now sinking the sector.

 Instead of listing some of the widely publicized grim statistics on the state of the housing and related sectors, I wish to mention the recent findings of a direct correlation between the housing market and the S&P 500, as determined by Merrill Lynch’s economist David Rosenberg. During the last twenty years the National Association of Home Builders (NAHB) housing market index (HMI) has led the S&P 500 by 12 months with nearly 80% accuracy.

 Over the last six years the correlation between the HMI and the S&P 500 has become especially close as the real estate has become a dominant influence on the U.S economy as well as on the financial markets index. Details on the HMI can be found on (www.nahb.org).

 The previous HMI top was made between June and September 1999. A year later the S&P completed the 2000 top and followed it down. Subsequently the HMI index bottomed out during October-November 2001 and the S&P 500 followed up again, starting a new bull market in October 2002. The last HMI top was formed in June-July 2005. Since then the index has experienced nearly a 50% decline, a development that does not bode well for the S&P 500, or the U.S. economy.

 Another leading indication of the housing bubble bursting was provided by the large sell-off in stocks of U.S. home builders. The chart of the two largest builders (Pulte and Lennar), both with revenues in the $15-$16 billion range, show losses of 45% from their July 2005 all-time highs. This reflects the extent of problems facing the sector as well as the discounting ability of equity markets.

 The clear signs of deterioration in a crucial segment of the economy probably played a big role in the decision of the Fed to hold interest rates unchanged during the August 2006 FMOC meeting. Discounting the impact of contraction in the housing sector on the U.S. economy, leading to eventual cuts in short-term interest rates, bond investors have bid-up the prices for mid-term and long-term maturities. As a result, the yield of 5 and 10-year treasuries pulled back from their recent highs, with the yield of 10- year treasuries dipping to 4.79%. The decline in 10-year yields, while the short-term rates held steady and well above the long- term yields, has deepened the yield inversion.

 Bottom Line: Based on the relationship between the National Association of Home Builders (NAHB) housing market index (HMI) and the S&P 500 over the past 20 years, we could be looking at sharply lower general stock prices in the 12 months ahead.