Plenty of experts think "for sale" signs on Elm Street are bad for stocks on Wall Street. Merrill Lynch & Co. (MER ) economists say housing is "undeniably in recession" and "the only question left is whether this morphs into a general recession." That would be a major bummer for Wall Street. Pessimists are citing some scary numbers: The government announced on Sept. 19 that housing starts in August fell 20% from a year earlier, twice the drop economists expected. And in a sign that starts could fall even more, an index of homebuilders' optimism plunged in September to its lowest level since the banking crisis of 1991.
Don't panic, though. History shows that the stock market can hold up as long as a housing slowdown doesn't foreshadow -- or cause -- a recession. For example, in 1995 builders' confidence slid sharply. But because the economy merely paused without shrinking, the stock market kept rising. Today, many economists believe that the economy, and Wall Street, will once again shrug off housing's troubles. "The markets are increasingly compartmentalizing their concerns about housing," says Michael R. Englund, chief economist of forecaster Action Economics.
Bears worry that a housing downturn will hurt because it accounted for such a big share of economic growth over the past five years. The real estate boom created tons of jobs in construction, sales, lending, and related industries. Plus, it gave consumers billions in extra spending power through cash-out refinancing, home-equity loans, and the like.
But the employment hit in homebuilding is being offset by growth in nonresidential construction. As for the hit to consumption, there's no sign of it yet, and there may never be much of one. Americans may just continue to spend even though their houses are worth less. A 2005 research paper by economists Karl E. Case of Wellesley College, John M. Quigley of the University of California at Berkeley, and Robert J. Shiller of Yale University concludes that while increases in housing wealth spur consumer spending, surprisingly, "declines in housing market wealth have no effect at all upon consumption."
The Federal Reserve knows housing could trash the economy, so at its Sept. 20 meeting it left interest rates unchanged. The Fed may even start cutting rates soon, which would be a big plus for the stock market.
Investors are betting Wall Street will emerge from the housing slowdown unscathed: The Standard & Poor's 500-stock index is near a five-year high, having risen 8% since June, while the news on housing has gotten steadily worse. Even homebuilding stocks have been rebounding lately. Since their lows in early September, Pulte Homes (PHM ) and D.R. Horton (DHI ) are up 12%, while Lennar (LEN ) and Centex are both up 7%.
Nothing is certain in the stock market, of course. "Right now most investors are assuming that [Fed Chairman Ben] Bernanke is going to pull off a soft landing," says Alfred Goldman, chief market strategist for A.G. Edwards & Sons Inc. "If the housing market gets washed out big time, the odds of a hard landing and a recession go up substantially." In that case, says Goldman, stocks will surely suffer. True enough. But right now, it looks like investors have a fighting chance to make up in their stock portfolios at least a little of what they lose on their homes.
By Peter Coy