Housing: Why All the Huffing and Puffing?

History shows a correlation between housing declines and recessions

by Sam Stovall From Standard & Poor's Equity Research

In the past few weeks, news and forecasts surrounding the housing decline—which began in 2005 and is projected by S&P Economics to bottom during the first half of 2008—appear to have renewed worries.

For nearly a year, David Wyss, Standard & Poor's chief economist, has been predicting that the housing slump would subtract 1.0% from U.S. gross-domestic-product (GDP) growth in 2007 and 2008. What's more, Wyss thinks the median price for homes across the U.S. will decline 11% from the peak in 2005 to the projected trough in the first half of 2008. He has also been saying that things are likely to get worse before they get better.

We think increased investor concerns (besides the 10.2% plunge in September's U.S. housing starts to 1.191 million, the lowest level in 14 years) could be related to history lessons, which show a high correlation between declines in residential construction and recessions, according to Jim Stack of InvesTech Research. Every recession since 1960 has been accompanied by a year-over-year decline in residential construction, which includes new home construction and home improvements.

During this housing cycle downturn, S&P and Global Insight, an economic forecasting group, see the year-over-year decline in residential construction bottoming in the first quarter of 2008 at –20.8%. We expect this trend to turn positive in the second quarter of 2009.

Though all recessions have been accompanied by construction declines, not all construction declines resulted in recessions. In both 1967 and 1995, there were year-over-year declines in residential construction, but the U.S. escaped recessions. In 1995, we think a recession didn't occur because the housing decline was the second shallowest of all 10, with a 7.5% fall during the second quarter. The construction decline was also fairly short, lasting only four quarters, as opposed to the decline of 1973-74, which lasted nine consecutive quarters. (During the recession of 1980-82, 14 months showed year-over-year declines, but there was one positive month in the midst of that run.)

Another reason the 1995 housing slump may not have triggered a recession, in our opinion, was that the Federal Reserve acted fairly quickly to reverse the effects of the seven Fed funds rate increases from February, 1994, through February, 1995 (6.0% from 3.0%). The Fed changed course five months later and cut rates over the period of July, 1995, through January, 1996, to 5.25%. Also, U.S. real GDP slowed to a 2.0% year-over-year gain in the December, 1995, quarter. The S&P 500 index declined modestly (–8.9%) from February, 1994, through February, 1995, possibly in anticipation of a housing slowdown in 1995 that did not materialize into a recession, despite the prior Fed rate increases.

The housing slump that lasted from the fourth quarter of 1964 through the first quarter of 1967 saw a 22.9% year-over-year decline in residential construction but did not lead to a U.S. recession. The S&P 500 also incorrectly anticipated a recession in that period, losing 22% of its value from February to October, 1966. In March, 1966, the U.S. economy peaked at an 8.5% year-over-year increase in real GDP, and bottomed in June, 1967, at a 2.4% rate of growth. It fell into recession two-and-a-half years later. Fed policy was on hold in 1966, after the Central Bank gradually raised the discount rate from 3.0% in August, 1960, to 4.5% in December, 1965.

Wyss pegs the likelihood of a recession at 33%, and the reason we don't expect this to happen is due to the breadth of the overall economy and foreign investors' interest in a weakening dollar and the dollar's positive impact on export demand. We also expect a proactive Fed and Treasury Department to get ahead of a recession curve. Indeed, we see the dollar continuing to weaken in the months ahead, as the Federal Reserve cuts short-term rates at least once more before the January, 2008, Federal Open Market Committee meeting. We think a lower dollar will help boost growth in exports, which we see rising 9.5% in 2008, following a 7.3% advance this year, helping to offset a decline in consumer spending of 2.2% we see for 2008 from our estimate of a 3.0% increase for 2007. These cuts should also help profits rebound.

Stovall is chief investment strategist for Standard & Poor's Equity Research Services .