Thanks to my friend Brian Wesbury for this interesting piece on housing. I am still much less sanguine than Brian about the housing market, although I agree with his conention that the reverse wealth effect doesn't have to be terrible when real estate prices weaken.

Claymore Monday Morning Outlook
By Brian S. Wesbury, Chief Investment Strategist
and Bill Mulvihill, Senior Economist

http://www.claymore.com/Research/research.aspx

Print Version With Weekly Data and Forecasts Click Here

Stocks, the Yield Curve, and Housing

Despite fears about a flattening yield curve, the S&P 500 and the NASDAQ closed at 4 ½ year highs on Friday. Since the Fed began hiking rates on June 30, 2004, the S&P 500 is up 9.1%. Include reinvested dividends and the total return is 13.8%.

They say every bull market climbs a wall of worry, and this one has had a steep climb. When the Fed first started hiking rates, authoritative and oft-repeated research argued that stock markets don't go up when the Fed hikes rates. Obviously, this has not been the case.

Another area of concern has been the housing market. While we are not fearful of a bursting bubble, we have expected a leveling off of housing market activity. Some recent data suggests that rising interest rates have finally begun to have an impact.

This has created a great deal of fear and many believe that any slowdown in housing could drag down the entire economy. The extent of the expected damage is forecasted by looking back and estimating the percentage of past economic activity related to housing. One analyst found that 36% of job gains between 2001 and 2005 were created in construction and real estate.

But this argument commits a "fallacy of composition." It is true that housing has added to growth. It is not true that the economy would have suffered without housing activity. Nominal growth is determined by Fed policy. Exactly where that growth occurs is determined by other factors. For example, the 1997 cut in the capital gains tax rate has lifted housing market activity above overall economic growth, causing it to represent a disproportionate share of the nominal GDP growth.

If tax rates on housing had not been cut, Fed accommodation during recent years would still have generated faster nominal GDP growth. But, activity in non-housing areas of the economy would have accelerated more. If housing slows, the resources and capital that would have been spent in that sector will be diverted to other economic activities. As a result, a housing slowdown will not hurt the overall economy.

In fact, a slowing housing market may be one reason the equity market has recently come to life. While many see a flat yield curve or housing slowdown as a threat, we remain bullish on the economy and still believe the stock market is undervalued by 30%.

Print Version With Weekly Data and Forecasts

BSW
WJM

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