This past Tuesday marked the 5-year anniversary of the S&P 500’s peak. On October 9, 2007 the S&P closed at 1,565. The chart below shows the monthly cumulative change from the peak in the S&P and the Case-Shiller Home Price Index. The Case-Shiller index peaked in July 2006.
60 months later, through the grips of the worst recession in 80 years, the S&P is off only 7% from its all-time high while houses are off 30% after 72 months.
This shouldn’t be a surprise. Reinhart & Rogoff, in their exhaustive research on financial crisis, have showed us that stock markets typically fall 56% in credit infused recessions while housing prices typically retreat 35%. The current fall in these asset prices exactly match those longer term averages.
Reinhart & Rogoff also taught us that stock prices recover much faster than housing prices. In fact, almost twice as fast. Why is this true? Mainly because stock prices are discounting mechanisms. This means that the price of a stock today reflects future cash flows. In other words, the fact that companies have booked losses or profits yesterday should not impact the stock price today. The good & bad news for stocks is that they are extremely sensitive to what the future holds. And through the power of discounting future cash flows out many years, it is empirically possible for only a hint of better times in the future to result in healthy gains in the present.
The stock market does this with much more precision and efficiency than other asset classes such as real estate. This helps explain why the S&P is within a spitting distance of its all-time high while the real estate market is at least a half-marathon away. Unfortunately, the inverse holds just as much. In other words, stocks will do poorly if they sense a sustained future economic degradation.
Home prices, too, will eventually reach their peak prices. But I would hold back your optimism about quick gains off these levels. Cullen Roche has a good summary of the current “recovery” in house prices that you can link to here.