Investing Insights

LEADING INDICATORS WATCH  •  July 22, 2024  •  Jon Wolfenbarger

Disconnect Between Housing, Economy And Stocks Means Trouble

PARIS, FRANCE — Housing demand is driven heavily by interest rates, which is why the Fed’s constant manipulation of interest rates causes recurring housing booms and busts, as we have seen in recent decades. This is why housing in one of the most important leading indicators for the overall economy, which is why we at Bull And Bear Profits watch it so closely.

Unfortunately for housing demand, mortgage interest rates have more than doubled to nearly 7% over the past couple of years. And median home prices are now nearly six times higher than median household income, making housing unaffordable for many Americans. That is even higher than during the housing bubble peak of the 2000s, as shown in this chart. 

Source: Trahan Macro Research

Leading Indicators Continue To Point To Recession

That’s why it should come as no surprise that home builder confidence remains near the weakest levels in history. As shown below, the National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI) fell to 42 in July (blue line). That is well below the neutral 50 level and the lowest reading since December. It is a level typically seen during recessions, such as the early 1990s, 2008-2009 and 2020. It is even weaker than the levels seen in the early 2000s recession. Current sales conditions fell to 47 and traffic of prospective buyers fell to only 27, while sales expectations in the next six months increased slightly to 48. Meanwhile, new housing starts (red line) fell -4.4% year-over-year, while new housing permits fell -3.2%.

Source: NAHB

Building permits are one of the 10 components of The Conference Board’s Leading Economic Index (LEI). As this chart shows, while the year-over-year decline in the LEI has improved this year, it is still down by a similar magnitude as it was at the beginning of prior recessions. Thus, we do not think this recent lessening in the rate of decline proves there will not be a recession after the most aggressive Fed rate hikes in over 40 years.  

Source: The Conference Board

Justyna Zabinska-La Monica, Senior Manager of Business Cycle Indicators at The Conference Board, summarized their June LEI as follows:

“The US LEI continued to trend down in June, but the contraction was smaller than in the past three months. The decline continued to be fueled by gloomy consumer expectations, weak new orders, negative interest rate spread, and an increased number of initial claims for unemployment. However, due to the smaller month-on-month rate of decline, the LEI’s long-term growth has become less negative, pointing to a slow recovery. Taken together, June’s data suggest that economic activity is likely to continue to lose momentum in the months ahead. We currently forecast that cooling consumer spending will push US GDP growth down to around 1 percent (annualized) in Q3 of this year.”

Let’s dig into the details of the LEI for some better perspective. 

This table shows the 10 components of the LEI. Over the past six months, six of the 10 components have been negative contributors.

Source: The Conference Board

Two of them are related to manufacturing: average weekly hours in manufacturing and manufacturers’ new orders for consumer goods and materials. Manufacturing has been weak for a couple of years, but it is currently being aided by an increase in government defense spending and autos, which are catching up due to underproduction during the covid lockdowns. Manufacturers new orders ex-defense and aircraft are down -0.2% year-over-year. So manufacturing is not exactly inspiring right now.

The other two positive components are driven by investor psychology, which remains more bullish than ever: S&P 500 stock prices and the Leading Credit Index. As the recession kicks in and corporate earnings begin to disappoint, we expect investor psychology will take a turn for the worse, which will lead to declines in both of those components and further weakness in the LEI.

Despite All Of This, Investors Are More Bullish Than Ever

Investor excitement over AI and possible future Fed rate cuts — which have not prevented recessions or bear markets in the past — has driven stock market valuations to all-time high levels. 

The chart below shows the stock market valuation metric that best predicts future returns for the S&P 500 (one of the 10 components of the LEI) over the next 10-12 years, based on the exhaustive research of economist and fund manager John Hussman. It is similar to Warren Buffett’s favorite metric, total market capitalization divided by GDP. It is currently at the highest level in history, even higher than at the market peaks in 1929 and 2021. Based on a century of data, this metric predicts the S&P 500 will likely be at least 50% lower in 12 years.

Source: Hussman Strategic Advisors

Despite signs of recession from leading economic indicators and all-time high valuations implying negative returns for the coming decade or more, investors are incredibly bullish. The chart below shows the Rydex Asset Ratio, which is the ratio of investor holdings of bearish Rydex funds (money market and bear funds) to bullish Rydex funds. This ratio is currently at the lowest levels in over a quarter of a century, outside of the late 2021 peak (before the 2022 bear market, which occurred without a recession). This is one among many indicators that prove investors are extremely bullish on stocks right now, which is a contrarian bearish sign.

Investment Implications

Housing and other leading economic indicators are pointing to a recession. Despite this, stock market valuations are at the highest level in history and investors are incredibly bullish on stocks. 

This provides two important lessons for wise investors: 1) in the short-run, the stock market is ultimately driven by investor psychology and mass herding, rather than fundamentals and 2) the fundamentals of a coming recession combined with record-high valuations will likely lead to significant losses for most investors.