Sunday, May 13, 2007

Conspicuous Correlation

A lot has been made in recent years about the “wealth effect” associated to the unprecedented home value appreciation seen during the historic housing boom and its consequence on consumption and the general economy.

As the theory goes, as home values increase, homeowners “feel” wealthier, either directly through home equity withdrawal or indirectly by simply observing the increased value of their home asset.

The outcome is an increase in consumer confidence and, in turn, consumer spending, particularly on discretionary items.

Of course, this effect can work the other way as well, that is, as home values decline, homeowners, feeling a decline to their wealth, may pull back on spending.

It’s important to consider that, given the reckless lending and borrowing seen during the latest housing boom, it’s likely that consumers are not only going to feel their housing wealth decline, but also the burden brought by servicing their outsized debt obligations.

Either way, the “wealth effect” is a particularly important macroeconomic phenomenon as personal consumption accounts for over 70% of GDP.

So the key question is, has the recent decline in housing had a measurable effect consumer spending?

The answer appears to lie in data released in the Census Debarments Retail Sales Report which tracks total receipts at stores that sell durable and nondurable goods.

To reveal the trend, I have combined several of the key, discretionary retail sub-category results into a single “discretionary” retail sales series, and then charted the year-over-year percentage changes since 2000.

I then added the year-over-year percentage changes of the S&P/Case-Shiller Composite index which broadly and accurately tracks single family home prices using data from Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco, and Washington DC.

The result is a significant correlation between the deceleration, and now outright decline, of home prices and a deceleration and subsequent decline in consumer spending.

The first chart (click for larger version) shows the complete series comparison from January 2000 to the latest reported months of 2007.

Note the precipitous deceleration and decline to home prices starting in January 2006 and the very well correlated decline in “discretionary” retail sales.

Also note that the latest decline to retail sales is easily the most significant and sustained seen since 2000, handily surpassing the decline that occurred during and preceding the 2001 recession.

The second chart (click for larger version) simply isolates the results from January 2006 in order to provide a clearer view.