Is housing a driver or passenger?

Last year at this time I cited a chart from ECRI to indicate that 2006 was unlikely to see recession and that the robust economic performance was evidence for remaining sanguine in spite of the likelihood of burst in our little real estate bubble in 2006. As we escaped the year with only a little Q4 slowdown, it looks like they hit it on the head.

This year, I'll revisit the same index. It turns out the chart shape is similar, as is the conclusion. We have indeed seen the signs of trouble in some parts of the housing market. New home construction has just started what is probably a multi-year decline, the mortgage business is sending many entrepreneurial souls off to their next venture. With the auto business tanking, these must be the canaries in the coal mine (to quote Barry Ritholtz), right?

For now, the dynamic US economy is holding on strong. While indeed in cyclical downturns, the economy is not just housing and autos.

You might think that if manufacturing slows more than the markets expected, it would raise recession risks -- especially with the weakness in housing. Luckily that isn't so.

This is now a two-speed economy. With industrial growth still slowing [it peaked months ago] but non-industrial growth is perking up. And that's the message from the ECRI leading services index.

But does that make sense? Can falling home prices, slowing industrial growth, and accelerating services growth add up an expanding economy?

Yep. According to ECRI it does. Their Weekly Leading Index is heading up, with growth rate at a 47 week high.

Source:Economic Cycle Research Institute. BusinessCycle.com

I like this index because 1) It is a weekly, real-time sample. It is therefore very aware of what is happening right now. Further, it is less subject to big revisions when new data comes in. 2) It is consistently right about predicting recession, and 3) maybe more tellingly, it has never cried wolf - their index has never predicted a recession that didn't come. The folks at ECRI say that the index must be persistently and pervasively below zero on the graph above before a recession is in the near-term cards. ECRI smugly puts it this way:

Not in 1995 when pessimists decided that recession was bound to follow Fed rate hiks. Not in 1998 after the LTCM crisis, when President Clinton spoke of the worst financial ciris in 50 years. Not in 2002, when stocks were plunging and the markets were rife with talk of doudle-dip recession. Not after Katrina and yes, not now, even with the yield curve clearly inverted.

So despite obvious weakness, the housing market escaped major carnage in 2006. Much of that relative success can be attributed to the strong economy, at least in the markets that Altos Research monitors. So in many ways, the housing market - at least the existing home resale part of it - is as much a passenger in this economy as a driver.

One caveat: Both the bulls and bears could still be right - with the difference being time horizon. Nouriel Roubini, for example, has indicated 70% chance of recession in 2007. While the ECRI index is powerful, it only looks about 9 months forward. Maybe 4Q 2007 is where we feel the pain.

Another caveat: the existing home sales market was spared in 2006 by persistently low mortgage rates. Our much-maligned, persistently high trade deficit is somewhat to credit for this. Cash flows out of the country for consumer goods, it returns in investment - demand for bonds - which keeps rates low. But in the last few months the trade deficit has been declining, signaling a possible rise in rates in '07.