If housing slumps, how safe are you?

By Amey Stone

updated 10:11 a.m. ET Oct. 4, 2005

If you take comfort thinking that your well-diversified investment portfolio is bound to fare well even if housing values decline significantly, think again. True, that rationale has panned out before. For example, someone who sold a house in the Northeast in 1991 and put the proceeds into the stock market would have missed a decline in real estate values and enjoyed stock market gains for the rest of the decade.

Investment strategists say it probably won't work that way next time around, however. That's because stocks and bonds — indeed, the whole economy — are now more closely tied to the real estate market than in the past. Although most experts think home prices wouldn't drop more than 20 percent or 30 percent over a couple of years if the much-discussed bubble bursts, even a small drop in prices could do serious damage to equity and fixed-income portfolios, they warn.

"If real estate cools dramatically, there goes half our economic growth," says Barry Ritholtz, chief market strategist at Maxim Group. "There is danger of recession — and you know what recessions do to the stock market."

Stress test for banks
As for hopes that the stock market would take over for a flagging real estate market, "I don't think it's that simple anymore," says Barry Hyman, equity market strategist with Ehrenkrantz King Nussbaum in New York. He points out that a bread-and-butter index fund based on the S&P 500-stock index now has significant exposure to real estate through the financial-services and consumer sectors.

The financial-services sector makes up 20 percent of the S&P 500 and has benefited from the mortgage refinancing boom driven by lower interest rates. This leaves companies in that sector vulnerable if trends reverse. In a Sept. 15 report, S&P credit analyst Victoria Wagner conducted a "stress test" on banks, assuming a 20 percent decline in home prices over two years (which she considers unlikely). The top 10 hardest-hit banks in that scenario included widely held stocks like Wachovia, Wells Fargo, and JPMorgan Chase.

Consumer-oriented stocks like retailers or restaurant chains, which make up 13 percent of the S&P, would also suffer if real estate declines. "There's a very widespread fear that if property prices go down and the refinancing boom goes away, that consumers are going to have to cut back on spending. And that will be felt throughout the economy," says Dan McNeela, a senior analyst at Morningstar.

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