Long-Term Growth in Housing Prices and Stock Returns

Abstract:     
We document a very strong negative association between a firm’s stock returns and previous housing price growth in the state where the firm is located. This relation is a long-term phenomenon, with much stronger effects at longer horizons than at shorter horizons. For the period 1979-2002, a strategy consisting of taking long (short) positions in firms located in states with four-year growth in housing prices in the bottom (top) quintile yields an average hedge-portfolio buy-and-hold abnormal return of about 25% over the subsequent four years. The average hedge-portfolio monthly abnormal return over the four-year period is about 0.40% when we use Carhart’s (1997) four-factor model.

The housing price effect is persistent, and robust to controlling for the long-term stock return reversal effect, changes in mortgage interest rates across the states, cyclicality in housing prices, and overall local economic conditions. We also find no evidence that extant asset pricing models can adequately explain the effect. Our analyses instead suggest that growth in local housing prices induces demand for local stocks and temporary increases in the prices of these stocks, leading to a negative association between growth in local housing prices and future returns of local stocks.

Our findings have important implications not only for the asset pricing literature but also for the emerging literature on the causes of the 2008/2009 stock market collapse. We conduct our analysis over the 1979-2002 period (i.e., prior to the recent credit crisis). The strong persistence of the housing price effect and the exceptionally high growth in housing prices that preceded the stock market collapse suggest that, unless the documented relation between housing prices and stock prices had drastically shifted, a severe stock price correction was bound to occur (even in the absence of the credit crisis). Accordingly, efforts to isolate the effects of the credit crisis need to consider the specific impacts of the unprecedented growth in housing prices that preceded, and likely affected, both stock returns and the crisis.

Keywords: Housing prices, Home bias, Stock mispricing, Trading strategy, Economic crisis

JEL Classification: G11, G12, G14, R3

Accepted Paper Series