Where to Invest When the Housing Market Cools
We all know that stock prices are more volatile than real estate prices. The graph to the right shows stock index and house price appreciation data for the past 30 years (source: Yahoo for stock indices, OFHEO for house prices). Stock prices tend to bounce around quite a bit, while real estate prices move in a slower, more predictable fashion.
From an asset allocation perspective, what is of interest is the degree of correlation between stocks and real estate. As might be expected, the S&P 500 and Nasdaq stock indices have a high positive correlation of 0.80. When one goes up, so does the other. Similarly, the two stock indices tend to fall in tandem.
Real estate prices, on the other hand, have historically shown little relationship to stock prices, as indicated by the tremendous degree of "scatter" in the diagram to the right. The correlation of the S&P 500 stock index to U.S. median house prices is, in fact, slightly negative (-0.18), based on data from the past 30 years.
What's the implication? My interpretation is that, as the housing market cools, the stock market will likely become an increasingly attractive place to invest, consistent with the slight negative correlation between the two asset classes. 2005 was a year in which house prices (12% year-on-year increase in U.S. median house prices for period ending the third quarter of 2005) outperformed the stock market (3% return for the S&P 500). I expect that during 2006, it will be the stock market's turn to play a little catching up, as investors shift some of their speculative capital from rentals and second homes into stocks and mutual funds.