Merrill Lynch's famous chart isn't as bad as it looks

Peter Coy

Let me start off by saying that the following isn't meant as a criticism of David Rosenberg, Merrill Lynch & Co.'s chief North American economist. He produces some of the most interesting work of any economist on Wall Street, especially on housing.

That said, I think a chart that Rosenberg or his team put together--which seems to show that housing may soon drag down the stock market--makes things look much scarier than is warranted by the facts.

Here's what Merrill put out. (I reconstructed it from the original data, but it's the same pair of lines.) The chart has been circulating among economists and investment advisers and was specifically mentioned to me last week by two non-Merrill economists, who said it made them very worried about the stock market.

The concept is that the S&P 500 closely follows, with a one-year lag, the ups and downs of the National Association of Home Builders' index of homebuilder sentiment. Since the NAHB index has plunged over the past year, then if history repeats itself the S&P 500 will plunge over the coming year. Seems reasonable, right?

Not so fast. For an article I wrote in the current issue of BusinessWeek, I traced the history of those two series back farther, to when the homebuilder index began in 1985. And as you can see below, the S&P 500 trended steadily upward throughout the period despite big swings in the homebuilder index. The tight correlation isn't there at all. Technically speaking, there's actually a small negative correlation, meaning a slight tendency for the lines to move in opposite directions.

What explains the difference between the first chart and the second? One difference is that there was a recession in 2001, and the recession helped kill the stock market. In the mid-1990s, homebuilding softened but there was no recession. And with no recession, there was no reason for the stock market to crap out. That implies that if the economy manages to avoid a housing-induced recession this time, the stock market might ride out the turbulence just fine. That's the evidence so far, anyway: The housing market keeps getting worse, and stock investors keep bidding up shares.

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