Housing Is the Financial Cycle: Evidence from 100 Years of Local Building Permits

Abstract

Does the housing market lead the financial cycle, and if so, why? We address these questions by creating a new hand-collected database spanning a century of monthly building permit quantities and valuations for all U.S. states and the 60 largest MSAs. We show that the option to build embedded in permits renders volatility in residential building permit growth (BPG) a strong predictor of aggregate and cross-sectional stock and corporate bond returns and volatility. This predictability remains even after conditioning on corporate and household leverage, mortgage access, commodity price risk, and firms’ exposure through their network of plants to other localized physical risks like natural disasters. Cities and states with more elastic housing supply consistently predict financial market downturns at 12-month horizons, admitting new trading strategies to hedge against overbuilding risk. A noisy rational expectations framework in which local building permits serve as a quasi-public signal for dividends explains these empirical patterns.

Keywords: housing supply, building permits, real estate, option value, volatility, financial crises, equities

JEL Classification: E32, G01, G12, N22, R31