How a Stock Market Crash Will End the Economic Recovery

What Happens When the Stock Market Crashes?

The stock market is holding up the economic recovery. A crash will end it.

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Things derive their being and nature by mutual dependence and are nothing in themselves.” – Nagarjuna, Indian Buddhist Philosopher

A Stock Market Crash Would End the Housing and Economic Recovery

The two pillars of the current economic ‘recovery’ are the stock and real estate markets. That is how the Fed engineered it with their multi-year, multi-trillion dollar quantitative easing (QE) programs. QE has been particularly effective in pushing the stock and real estate markets higher. Rising stock and real estate markets are often cited as evidence of overall economic recovery. This foolish assertion can be rejected easily by referring to the declining labor participation rate and lack of wage growth. Measured by job and wage growth, the current recovery is worse than the recession from which the economy supposedly emerged.

Since the economic recovery rests its support on rising stock and real estate prices, a crash of the stock market would devastate the other pillar of the economic recovery, the real estate market, and put an end to the economic recovery altogether.

It’s Easier to Pump up the Stock Market than the Real Estate Market

The Fed has been very successful in proving that you can reheat a soufflé. The current stock market bubble now exceeds its pre-2008 crash levels. Stock market bubbles are easier to blow up as there is no limit to how high stock prices can go. Once the market accepts thin air valuations for non profitable companies that are untethered to dividend yields and traditional valuations, beyond the sky is the limit. Homes may become too expensive to afford but no stock becomes too expensive or unaffordable; anyone can buy any stock, albeit in smaller amounts. Stock prices, unlike home prices do not have their upward trajectories limited by availability of credit, loan to value ratios, employment history, affordability and income levels.

With interest rates on bonds and bank certificates of deposit artificially low and near zero, money seeking higher returns flows into the stock market pushing prices higher. Companies can create further demand and give the illusion of higher profitability by buying back their shares with cheaply borrowed cash.

The flip side to these advantages is the stock market can also crash in an instant and with it take away all the economic “gains” of the past few years.

The False Housing Recoveries of 2013 and 2014

The housing recoveries of 2013 and 2014 were characterized by low inventory, low sales and higher prices ginned up by QE that drove down interest rates making home purchases more attractive for investors who had access to the cheap capital.

Home prices have risen over the past two years even though employment rates and wages have not increased. Indeed, the disconnect between the housing and labor market is clear- the labor participation rate shows a decrease in the percentage of people employed in the United States and wages lower today than they were in 2009 at the end of the recession.

Pushing home prices higher by manipulating interest rates lower is more difficult than driving stock prices higher by using the same means. When the housing bubble burst in 2007-08 many homeowners either were forced into foreclosure or saw the values of their homes drop below the amount owed on their mortgages.

Last year, in Real Estate’s Underwater Downside Sticky Catch-22, we noted that the large percentage of underwater home owners was helping to keep housing inventories low.

Further adding to the housing inventory shortage are:

– home owners, encouraged by the recent increases in home prices, who may not have underwater mortgages, are waiting for higher home prices before they sell;
– lower than historic averages of new home building; and
– the slow release of foreclosed properties by banks.

Against a back drop of a housing inventory shortage (not a shortage of housing), low interest rates have boosted demand for investors who can fund home purchases with cash, qualify for mortgages or obtain independent financing.

While home sales ticked higher last year, they are still far off their 2003-2007 levels and when one considers that last year’s sales were boosted by all cash buyers who constituted 40%+ of all transactions, the number of homes purchased by traditional retail buyers is still at multi-year lows.

When the Stock Market Crashes

A stock market crash can occur for any number of reasons: events in China, Germany, emerging markets turmoil, the Fed’s tapering, rising interest rates, war or a terrorist attack.

Crashes happen and the current stock market is ripe for one.

A stock market crash would most likely lead to even fewer potential qualified home buyers. After a stock market crash, layoffs are common. Since employment is normally a prerequisite for non cash purchasers to buy homes, layoffs will drive down demand for housing. For example, rents and housing prices in the Bay Area have risen to stratospheric levels. After a crash, investors normally reevaluate the prospects of the companies they own especially ones with no earnings. Companies generally respond to falling stock prices by laying off workers in an attempt to reduce their losses. Layoffs in the Bay Area would reduce the number of qualified buyers from the market and take some of the froth off the record high San Francisco home prices. A dynamic of reduced employment and employment prospects caused by a stock market crash would have a similar impact on housing demand and prices across the country.

Investors and all cash buyers who make up well over 40% of national home sales, (in some markets over 60%) will also exit the real estate market after a stock market crash as their coffers of investible capital and collateral are drained.

Who Will Buy Homes when Investors Can’t or Won’t?
Hint: It Won’t Be Millennials

First time home buyers are largely absent from the current housing market. Millennials have not been forming households at rates like predecessor generations and have been shut out of the market due to rising home prices, poor job prospects and crushing student loan debt.

Unless the economic prospects of millennials improve and home prices come down, they can’t be counted on to provide a meaningful pipeline of new home buyers to sustain the high priced housing recovery. We also can’t expect the the long term unemployed or the newly unemployed to purchases homes.

the economic recovery that wasn't

Midde innings of A Multi-Year Housing Recovery?

The health of the housing market is constantly made in reference to the price of housing, not the number of homes sold and their affordability. Many real estate observers like to refer to a housing (price) recovery as in its early stages as if it were a preordained event. Recently, Zillow’s Chief Economist noted “the housing recovery is entering the middle innings.”

After a stock market crash, a more apt analogy may be intermission at the Gong Show.

We would only be in the middle innings of a housing (price) recovery if the Fed decided to make QE a ten year program. Since the Fed is now on a course of ending the QE program without an alternative buyer, (other than perhaps mandating US citizens to buy US Treasuries for their retirement accounts) the prospects of rising home prices are dim. Lower home prices, however, are a good thing as lower prices will make homes affordable.

Janet Yellen: QE – It’s Not Just for Rich People!

In a recent Time magazine interview, Janet Yellen, incoming Chair Woman of the Federal Reserve, defended QE as being not just for rich people. “You know, a lot of people say, this is just helping rich people. But it’s not true. Our policy is aimed at holding down long-term interest rates, which supports the recovery by encouraging spending. And part of it comes through higher house and stock prices, which causes people with homes and stocks to spend more, which causes jobs to be created throughout the economy and income to go up throughout the economy.”

Ms. Yellen outlined all that is wrong with QE and the Keynesian approach to central planning of an economy. We will focus on just one of the flaws of such approach here. The converse of Ms. Yellen’s statement is also true. When QE ends and home and stock prices drop we will have less spending which will weaken the recovery. Thus, “Live by QE, die by QE.”

But What About Escape Velocity?

The Fed will soon learn that printing nearly $5 trillion out of thin air in order to buy U.S. Treasuries and mortgage backed securities from the too big to fail banks in order to drive down interest rates creates distortions in the economy and comes with consequences. Yet, the Fed believes that the economy can achieve escape velocity that will allow them to begin to step away from the money printing Frankenstein they have created and have begun the communication offensive to convince the markets that they did the right thing in printing nearly $5 trillion out of thin air and that they are doing the right thing to starting to slow the dollar printing press. They have also assured us that “tapering is not tightening” (it is) and that they will continue to hold interest rates low in the absence of QE.

What Will You Do If the Market Crashes? Take our Poll

What Happens After the Next Stock Market Crash?

End of the Road

QE has been described as papering over fundamental economic structural problems, bailonomics, and kicking the can down the road. The road is a dead end and we may be approaching the final mile.

Measuring the success of an economy by the value of the homes in it is misguided. Pursuing monetary policy to drive the prices of those homes higher is even more misguided. Rising real estate prices and home prices should not be counted on to drive the economy, but rather should be reflective of the health of the economy.

Higher home prices don’t reflect any improvements in the underlying economy, any added productivity, job or wage gains that allow people to afford more expensive better homes. Home prices have risen largely because QE has made it easier for a relative few to speculate on housing. QE has encouraged greater borrowing and spending of money people didn’t have and didn’t earn but rather received as a function of their home prices or stock portfolios rising.

Since the current recovery we have been hearing about in the media is based on rising stock and real estate markets, a collapse in them will put an end to the economic “recovery”.

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Economy Tombstone Image Credit: Can Stock Photos

Further Reading:

What Happens After the Next Stock Market Crash?

How to Buy Silver

How To Buy Gold

Mandatory Retirement Accounts

HSBC Limits Withdrawals – Are Banks Safe Places to Keep Your Money?

Welcome to the Revocery!-The “Recovery” has Reversed

The Dark Side of Rising Home Prices

The Dark Side of Artificially Low Interest Rates

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