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

Posted by: Peter Coy on September 26, 2006

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.

Reader Comments

matt carter

September 26, 2006 2:45 PM

"What explains the difference between the first chart and the second?"

Uh, the fact they document completely different 10-year periods in time?

The fact that homebuilder optimism didn't track with the S&P 500 from '85 to '95 doesn't mean it's not doing that now. But there's no reason to think it won't departing from the more recent trend of the last decade, either.

The problem with all of these attempts to look into the future by analyzing the past is that there are always new variables that get introduced.

Seems like it's much wiser to look at an individual housing market or house, or a specific industry or company, if you are thinking about investing in housing or stocks.


September 27, 2006 4:21 PM

I think we are seeing nation-wide alarmists scaring everyone before we know what really will happen, which left untouch, it would depend on BUYERS!

With dwindling viewers, the news media is pumping more and more sensationalistic headlines design to recapture viewers fading interest. The market in Long Beach is far better than the headlines make it. Unfortunately, with this self-fulfilling prohecy mode the news is on, more and more people will get scared which in turn will slow down the industry.

So it really isn't as bad as they make it, but read it long enough and it will be.


September 28, 2006 9:39 AM

Interesting how much we want to believe that this housing run up will be the end of us all. The correlation in the last few years does make a strong statement, that you counter balance by the previous ten years. But your chart begs the question: What happened before that? Should we keep going back to get a stronger sense, or is 1985 far enough back to understand the trend?

Peter Coy

September 29, 2006 2:23 PM

I see that Economist Ed Yardeni of Oak Associates made a similar point this past week:
"We've all seen the chart of the Housing Market Index (HMI) as a 12-month leading indicator of the S&P 500 by now. It isn't pretty. The HMI also correlates quite well with the y/y growth in real personal consumption expenditures. The plunging HMI suggests that the housing recession will shortly depress consumer spending and send stock prices into a tailspin. The market must recognize that the HMI only worked since 1996. It didn't work as a leading indicator of consumer spending or stock prices from 1986-1996."

David Schere

November 10, 2006 10:49 PM

There are some reasons to beleive that even now in November that the HMI might acurately predict the future.

1) What has lead the market higher off the July lows where defensive high market cap stocks. This is evident be observing the dow relative to the mid caops. This is not a bull market be rather a flight to safety. This has artificially inflated the major market indecies.

2) The US consermer is far more vulnerable then they where in the 90's. Job security is less, indebtedness of the consumer is greater not to mention all the geopolitical environment.

3) During the 90's we where in a bear market for commodities. In the 2000's we are in a commodity bull market, the recent slump in oil not withstandings, its still $55-60 a barrel oil, gold is above 600$ an ounce. This is added pressur on equities that did not exist in the prior decade.

4) Finally one must ask a simple question. What was the main growth engine for 2002-2006? The refi boom, the house became an ATM machine.

It will end poorly, all asset bubbles do.


January 29, 2008 1:47 PM

It is now Jan08.
Looks like David Rosenberg was CORRECT!


September 18, 2008 2:21 PM

David Rosenberg was bang on the money.
It is now September 18 2008.
He was right. Too bad nobody took his advice. His work is more than just "interesting".

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BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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