Since this decade began, Wall Street's major stock indexes -- the ageless Dow Jones Industrial Average (^DJI 0.40%), benchmark S&P 500 (^GSPC 1.02%), and innovation-driven Nasdaq Composite (^IXIC 2.02%) -- have vacillated between bull and bear markets. With all three indexes well off of their 2022 bear market lows, it would appear the needle is pointing higher on Wall Street... but looks can be deceiving.
At the moment, there is no shortage of economic datapoints and predictive indicators that suggest trouble is brewing for the U.S. economy. The first meaningful decline in U.S. money supply since the Great Depression, a 17-month drop in the Conference Board's Leading Economic Index, and only the fourth notable decline in commercial bank credit dating back 50 years, are all potential signals that economic activity is poised to slow.
Since corporate earnings tend to ebb and flow with the health of the U.S. economy, recessions typically coincide with poor performance for the Dow Jones, S&P 500, and Nasdaq Composite. Approximately two-thirds of the S&P 500's drawdowns since 1929 have occurred during, not prior to, a recession.
Image source: Getty Images.
But among this veritable sea of economic data, I believe there's only one catalyst capable of sending the U.S. economy into a recession and pushing stocks decisively back into a bear market: the housing market.
History has a way of rhyming on Wall Street
One of Wall Street's quirks is that catalysts tend to be repetitive throughout history. However, history doesn't precisely repeat on Wall Street. Rather, it rhymes.
Just 16 years ago, housing played a pivotal role in kicking off what's widely considered the worst recession since the Great Depression. Relatively loose mortgage-lending practices by banks and credit unions allowed people to buy homes with little or no money down and income that simply didn't justify the value of the home being purchased. When adjustable-rate mortgages began resetting from low/perk levels, lenders quickly discovered their mistake. Nevertheless, the housing crisis sent home prices tumbling and left a veritable mountain of bad mortgage debt sitting on bank balance sheets for years.
Things have certainly changed since 2007. Mortgage-lending practices have been updated to ensure that income verification steps are in place when issuing home loans. Additionally, the vast majority of home loans are now at fixed interest rates.
But while some things have changed, one thing appears to be the same: housing being a potential black swan event for the U.S. economy and stock market.
US Fixed Housing Affordability Index data by YCharts.
Right now, housing in the U.S. is the least affordable it's been since August 1985. A value above 100 signifies that a median income family has enough income to qualify for a mortgage on a median-priced home, assuming a 20% down payment. A reading below 100 suggests the median income family can't afford a median-priced home with 20% down.
To put this into some context, the average 30-year fixed mortgage rate in August 1985 was 12.2%. Things were more affordable then for median-income American homebuyers than they are today, with 30-year mortgage rates averaging about 7.5%.
With inflation soaring to a four-decade high of greater than 9% in 2022, the nation's central bank had no choice but to tackle this problem head on by aggressively raising interest rates. In doing so, it's sent 30-year mortgage rates flying to their highest level in more than two decades.
After years of being spoiled by access to historically cheap capital, prospective homebuyers have had this cheap capital quickly ripped away, which has completely frozen the housing market. According to findings from Redfin, nearly 92% of homeowners are locked into a mortgage rate below 6%, with 62% sitting on a mortgage rate below 4%. There's not much incentive for existing homebuyers to give up a historically low rate for one that could potentially top 8%, which is why existing home sales slipped to a more than one-decade low earlier this year.
30 Year Mortgage Rate data by YCharts.
Although homebuilders have stepped up their output, new homes come with drawbacks for today's prospective buyers, too. While lumber prices have fallen well below their 2021 and 2022 peaks, the nearly $500 price tag per thousand board feet is well above where things stood between 2014 and 2020. Long story short, new homes are pricing prospective buyers out of the market, too.
To complete the circle, landlords are well aware that rapidly rising mortgage rates have "trapped" prospective buyers in the rental cycle. This means landlords can increase rent with little fear of losing tenants.
The Federal Reserve finds itself in a very difficult situation. Increasing the federal funds rate 525 basis points since March 2022 has helped it reduce the prevailing inflation rate to a little more than 3% from north of 9%. However, core inflation (4.35%) remains more than double the central banks' long-term target of 2%, and it's being almost entirely driven by shelter expenses.
Given the dynamics of the housing market I described above, core inflation won't meaningfully decline anytime soon. If the Fed decides to ultimately cut interest rates, it risks reigniting inflation. If the central bank does nothing, the housing market could, once again, directly or indirectly thrust the U.S. economy into a recession and pull stocks into a bear market.
Image source: Getty Images.
Patience pays on Wall Street
I'll be the first to admit that the above scenario doesn't exactly inspire confidence in the Dow, S&P 500, and Nasdaq Composite in the months and quarters to come. But for investors willing to look beyond the next 12-to-18 months, there's plenty to smile about.
Though recessions are unwelcome events according to workers and investors, they're a perfectly normal and short-lived part of the economic cycle. Since the end of World War II, there have been 12 recessions. Nine of these 12 economic downturns wrapped up in less than a year, while none have surpassed the 18 months in length of the Great Recession (2007-2009). Despite all the concern of what may come next, the U.S. economy statistically spends far more time expanding than contracting.
It's a similar story for the Dow Jones Industrial Average, S&P 500, and Nasdaq Composite. Even though stock market corrections, crashes, and bear markets tend to catch investors by surprise, these are all natural and inevitable aspects of the long-term market cycle. With the exception of the 2022 bear market, every notable downturn in all three major stock indexes was, eventually, whisked away by a bull market. History suggests this'll be the fate of the 2022 bear market, as well.
The key point being that patience pays handsomely on Wall Street -- and the historic data proves it.
Data source: Bank of America Global Research. Chart by author.
Recently, Bank of America Global Research released a report that analyzed the probability of an investor generating negative total returns (including dividends paid) in relation to the total returns of the S&P 500 since the start of 1929. What the data showed was a clear correlation between time and probability of negative returns.
Since 1929, an investor who held for a single day had a 54% chance of generating a profit and a 46% probability of losing money. The likelihood of a loss shrank to 38% for a one-month holding, 32% over three months, and 25% if the position were held for a year. Most notably, if you held the S&P 500 -- or in this hypothetical instance, an S&P 500 tracking index -- over the course of 20 years, you would have generated a positive total return 100% of the time.
Things may appear bleak for the housing market now, but the future remains bright for the U.S. economy and for equities as a whole.
