By Amey Stone If you take comfort thinking that your well-diversified investment portfolio is bound to fare well even if housing values decline significantly, think again. True, that rationale has panned out before. For example, someone who sold a house in the Northeast in 1991 and put the proceeds into the stock market would have missed a decline in real estate values and enjoyed stock market gains for the rest of the decade.
Investment strategists say it probably won't work that way next time around, however. That's because stocks and bonds -- indeed, the whole economy -- are now more closely tied to the real estate market than in the past. Although most experts think home prices wouldn't drop more than 20% or 30% over a couple of years if the much-discussed bubble bursts, even a small drop in prices could do serious damage to equity and fixed-income portfolios, they warn.
"If real estate cools dramatically, there goes half our economic growth," says Barry Ritholtz, chief market strategist at Maxim Group. "There is danger of recession -- and you know what recessions do to the stock market."
STRESS TEST FOR BANKS. As for hopes that the stock market would take over for a flagging real estate market, "I don't think it's that simple anymore," says Barry Hyman, equity market strategist with Ehrenkrantz King Nussbaum in New York. He points out that a bread-and-butter index fund based on the S&P 500-stock index now has significant exposure to real estate through the financial-services and consumer sectors.
The financial-services sector makes up 20% of the S&P 500 and has benefited from the mortgage refinancing boom driven by lower interest rates. This leaves companies in that sector vulnerable if trends reverse. In a Sept. 15 report, S&P credit analyst Victoria Wagner conducted a "stress test" on banks, assuming a 20% decline in home prices over two years (which she considers unlikely). The top 10 hardest-hit banks in that scenario included widely held stocks like Wachovia (WB), Wells Fargo (WFC), and JPMorgan Chase (JPM).
Consumer-oriented stocks like retailers or restaurant chains, which make up 13% of the S&P, would also suffer if real estate declines. "There's a very widespread fear that if property prices go down and the refinancing boom goes away, that consumers are going to have to cut back on spending. And that will be felt throughout the economy," says Dan McNeela, a senior analyst at Morningstar.
NONPLUSSED AT THE PUMP. For one reason the market has held up despite the shock of higher energy prices, Hyman cites consumers who are enjoying wealth gains from their home (the latest government data shows existing home prices are up nearly 15% from a year ago on average nationwide).
"The perception is that they can withstand higher gas prices if a $700,000 home is up another $140,000 next year," he says. "Once you take that support away, we should expect a drop in consumer confidence and consumer spending, which makes up two-thirds of the economy."
Maxim Group's Ritholtz estimates that fully half of economic growth in the U.S. is tied to real estate -- including hiring, construction, and consumer spending. That means the entire market is hitched to housing. "You can be in tech stocks or energy, but from a macro perspective, if real estate takes a hit, you can expect all of your holdings to get ratcheted down," says Ritholtz.
WILL IT "END BADLY"? Even the fixed-income portion of your holdings may contain hidden real estate risks. Bond funds are often the safest part of an investment portfolio. But mortgage debt has boomed, and those loans are typically packaged into securities that are sold to fixed-income portfolio managers. Many of them end up in bond funds.
"You might not know what kind of exposure you have" to the riskiest sorts of mortgages, says Didi Weinblatt, portfolio manager of USAA GNMA Trust Fund. (She notes that mortgages in her fund are backed by the U.S. Treasury and are nearly all 15-year or 30-year fixed mortgages -- not the riskier adjustable-rate and interest-only loans that are so popular today). If interest rates rise while home values fall, she thinks some homeowners may choose to default on their mortgage, since they would owe more on the loan than the house is worth. "I worry it could end badly," says Weinblatt.
Mortgage risk in a well-managed mutual fund is likely small. But if you invest in hedge funds, you may be doubly exposed. Often these pooled mortgage securities are divided and repackaged further based on risk -- and the highest-yielding derivatives end up in hedge funds. "There's a layering of risk in mortgage loans that is unprecedented and untested in previous mortgage markets," S&P's Wagner wrote in her Sept. 15 report.
DO SOME DIGGING. Don't assume your stock portfolio is safe just because you don't own a lot of real estate investment trusts (REITs) and homebuilding companies, which combined account for just a percent or so of the S&P 500. Real estate funds, since they tend to own commercial, industrial, and rental properties, don't correlate much to the residential housing market, says Morningstar's McNeela.
So what can you do to protect yourself if you're concerned about the impact of a housing slump on your portfolio? First, you should make sure your stock holdings aren't too weighted toward consumer and financial names. Also, do some digging to find out if your bond funds contain risky types of mortgage-backed securities. Holding more of your savings in cash may make the most sense if you want to reduce your overall risk.
So far the real estate market is showing signs only of topping out -- not falling. But it's worth keeping in mind: If housing does take a turn for the worse, the stock and bond funds that don't necessarily seem tied to the real estate market may offer the biggest negative surprises.
Stone is a senior writer for BusinessWeek Online in New York