In the words of author Mark Twain, "History doesn't repeat itself, but it often rhymes." This aphorism couldn't be truer for Wall Street.

There are dozens of economic data points, predictive indicators, and performance-based metrics that have, throughout history, correlated strongly with the directional movements of the ageless Dow Jones Industrial Average (^DJI 0.40%), widely followed S&P 500 (^GSPC 1.02%), and growth-driven Nasdaq Composite (^IXIC 2.02%). Although the macro events, monetary policies, fiscal policies, and a host of other factors surrounding bull and bear markets of the past are all unique, these correlated moves are examples of history rhyming for the stock market.

Despite the first seven months of 2023 starting off with a bang for the S&P 500 and Nasdaq Composite, a case of déjà vu for Wall Street regarding the housing industry could bring this party to a screeching halt.

A miniature home set atop wooden building blocks, and a businessperson removing one of the blocks.

Image source: Getty Images.

The housing industry could be Wall Street's undoing for a second time in 16 years

Though there have been four bear markets since the century began, three really stand out: the dot-com bubble (2000-2002), the Great Recession (2007-2009), and the COVID-19 crash (2020). The latter took place in a matter of weeks and was driven by a once-in-a-century pandemic. Meanwhile, the dot-com bubble was fueled by "irrational exuberance," in the words of former Fed Chair Alan Greenspan.

The Great Recession, which was the longest recession (18 months) since World War II ended, was driven by a multitude of factors. Chief among them was a complete collapse in housing demand and home values.

The argument can rightly be made that the financial industry was behind the housing collapse witnessed during the Great Recession. Poor mortgage-loan vetting standards allowed people to purchase homes who weren't qualified to do so. Couple this with financial institutions packaging mortgage securities into improperly rated derivatives (in hindsight), and you have the recipe for disaster.

In 2023, there's little concern from lending institutions about the mortgage-loan vetting process. Nevertheless, housing could, once again, be the catalyst that sends the Dow Jones, S&P 500, and Nasdaq Composite markedly lower.

The issue this time around looks like a mix of the U.S. inflation rate and the Federal Reserve's monetary-policy actions.

A frozen housing market may spell trouble for the U.S. economy

Following a massive expansion of M2 money supply during the COVID-19 pandemic, the U.S. inflation rate spiked to a more than four-decade high of 9.1% in June 2022. Intent on getting the pace of rising prices under control, the nation's central bank embarked on its most aggressive rate-hiking cycle in decades.

US Core Inflation Rate Chart

US Core Inflation Rate data by YCharts.

While the rate of inflation for the all-encompassing Consumer Price Index for All Urban Consumers (CPI-U) has fallen from 9.1% to 3.2% over the trailing 13 months, core inflation, which excludes energy and food expenses, remains stubbornly high -- 4.7% in July 2023, versus a 2% long-term target by the Federal Open Market Committee (FOMC). This can be attributed to the largest component within core inflation: shelter.

According to the U.S. Bureau of Labor Statistics, "shelter" has two inputs. It's both the rental cost of a primary residence (for renters), as well as the value at which a primary residence could be rented at today (for homeowners). Shelter inflation over the past 12 months (on an unadjusted basis) came in at a scorching-hot 7.7% in July. 

The problem for the Federal Reserve is that it finds itself in a seemingly no-win situation. A cumulative 525 basis-point increase in the federal funds rate since March 2022 is beginning to weigh on the pace of price increases in certain areas of spending, outside of shelter. If the FOMC were to take its foot off the accelerator now, it would risk losing the progress it made on taming the pace of inflation.

But at the same time, 30-year mortgage rates are hitting 21-year highs, north of 7%. With almost 92% of homeowners locked into a fixed-rate mortgage below 6% and 62% paying less than 4%, the incentive to move and pay 7%+ for a 30-year fixed-rate mortgage is virtually nonexistent. 

US Fixed Housing Affordability Index Chart

U.S. Fixed Housing Affordability Index data by YCharts.

And it's not just that the incentive to move isn't there. With few existing homes being listed for sale, home values are remaining elevated, if not rising further, as mortgage rates rise.

The Housing Affordability Index, published by the National Association of Realtors (NAR), "measures whether or not a typical family earns enough income to qualify for a mortgage loan on a typical home at the national and regional levels based on the most recent price and income data," per the NAR. In 2023, housing is the least affordable it's been since 1985. 

To add fuel to the fire, mortgage-loan demand for new homes hasn't been this weak in nearly three decades.  

Renters aren't finding any reprieve, either. The rapid rise in interest rates has moved on-the-fence homebuyers back into the rental market. As more prospective buyers get priced out of owning a new home, landlords and rental-community operators have the liberty of raising rents with little pushback.

Two scenarios appear to exist at this point: Either the Fed will continue to push rates higher to drive down core inflation, which may mean pushing the U.S. into a recession, or it'll ease off the proverbial accelerator and risk a reignition of the inflation rate fueled by a historically tight and unaffordable housing market. Neither situation would be a win for the U.S. economy or stock market.

A smiling person reading a financial newspaper while seated at a table in their home.

Image source: Getty Images.

Time is the ally that keeps on giving for patient investors

Should history rhyme, once again, for the housing industry, the 2023 rally we've witnessed for the S&P 500 and Nasdaq Composite may prove to be nothing more than a sizable bear market rally. While the prospect of additional downside in equities might disappoint investors, time has a way of healing all wounds on Wall Street.

For instance, you might not realize that downturns in equities are actually quite common. Data from sell-side consultancy company Yardeni Research shows that there have been 39 double-digit percentage declines in the benchmark S&P 500 since the beginning of 1950. On average, we're talking about a double-digit decline every 1.89 years.

But what's even more commonplace is the outperformance of Wall Street during bull markets. With the exception of the 2022 bear market, the Dow, S&P 500, and Nasdaq Composite have all, eventually, recouped their losses tied to every other previous correction.

We'll never know ahead of time when a downturn will occur or how long it'll last. However, history is pretty clear that, over time, the major indexes will march to new highs.

To take this one step further, wealth management company Bespoke Investment Group examined the length of time the S&P 500 spent in bull and bear markets over the past 94 years. Bespoke defines a bull market as a 20% (or greater) rally following a 20% (or greater) decline. Meanwhile, a bear market is a 20%+ decline following a 20%+ rally.

Spanning 27 bear markets since September 1929, Bespoke found that the average bear-market decline for the S&P 500 lasted 286 calendar days. By comparison, the typical bull market since September 1929 has lasted 1,011 calendar days, or about 3.5 times as long.

The point is that time is an investor's greatest ally. No matter what black swan event has rattled Wall Street's cage throughout history, the major indexes, and many of their profitable, time-tested components, have eventually marched higher. Even if housing is Wall Street's undoing for a second time in 16 years, the long-term outlook for equities remains bright.