Following the leader

Response to Sept. 11, interest rate changes tied stock and home prices together

(GLOBE DIGITAL ILLUSTRATION/ANTHONY SCHULTZ/ISTOCKPHOTO.COM)

Nothing like a blowup of your retirement accounts to make you forget about those depressed home values.

Before the financial meltdown late this summer, the mutual misery topic of the moment was how no one was happy with where home prices were: Longtime owners couldn't borrow as much as they had planned to pay for the kids' college; newer owners were underwater and couldn't refinance to do that addition; sellers were dismayed at how low they'd have to go to make a deal; and prospective buyers, meanwhile, were still waiting for prices to fall even further so a home would finally become affordable. It was a good way to pass a cocktail party.

But the stock market plunge makes the housing markets woes look mild by comparison. Not that that's any source of consolation. Now the two main pillars of wealth for most Americans, their retirement accounts and their homes, are worth a whole lot less than most people probably ever accounted for.

It didn't use to be that way.

Chip Case, a Wellesley economics professor and cocreator of the widely followed Case-Shiller home price index, said housing and stock values have historically charted their own courses, with stocks growing in fits and starts, while home prices rose slowly. Since World War II, home values have steadily climbed, unperturbed by disturbances in the stock market, such as the crash of 1987 and the doldrums of the 1970s.

"If you think of housing as an alternative investment to stocks, even if it doesn't appreciate, it's still an earning asset, because it provides a valuable service," such as shelter and comfort, Case said. "The dividend is fixed in real terms. When Enron goes down, you have nothing."

It wasn't until the dot-com bust, Case said, that the fates of the stock and housing markets became intertwined.

With the double-barrel hit of the stock market decline and a recession sparked by the Sept. 11, 2001, terrorist attacks, the Federal Reserve Bank embarked on an aggressive policy of low interest rates to spur business growth. What happened was mortgage rates began a steady slide downward, fueling sales in the housing market and refinancing by existing homeowners, many of whom used the growing equity in their houses to take out cash and spend it. This increased spending had the effect of softening the economic downturn in the post Sept. 11 era.

"Every other recession we've had in the last 30 years, housing has dipped in the middle of it," Case said. "After the dot-com bubble burst, the Fed tried to prevent a recession in 2002-2003 by lowering interest rates, thinking the real estate sector could keep us out of it." The downside to that was that cheap loans allowed people to bid up house prices or buy more house than they could afford.

"Now we're paying the price," Case said: the bursting of the real estate bubble and a boom in foreclosures leading to a prolonged softness in the real estate market.

In the eyes of Case and other economists, homes were the safest and most desirable investment for decades because of their intrinsic value, not their potential for a big short-term profit. Looking at the extraordinary surge in home values starting in the late 1990s, however, it's not surprising that housing was seen as a great bet.

In a paper published last year, "Historical Turning Points in Real Estate," economist Robert Shiller noted that the "national home price boom since the late 1990s appears unprecedented in US history, although the 'baby boom' in housing of the late 1940s and early 1950s comes close, and there have been some very large local booms."

Shiller further writes that home buyers and stock investors during that period suffered from a similar set of false expectations. He called this, a "uniqueness bias," in which stock and home buyers overestimate how unique the investment they've made is and become blind to economic responses, such as new competitors or new housing supply that undermine the value of their purchases.

His description of that bias at work among home buyers may sound familiar to Boston-area residents: "The uniqueness bias has its effect in the housing market when people imagine that the city they live in is unusually attractive, and increasingly so," Shiller wrote.

A chart in Shiller's paper shows the S&P/Case-Shiller home price index, starting in the late 1990s, tracking a growth curve parallel to the S&P 500 stock index - until two years ago, that is.

The most recent Case-Shiller index reading, reflecting sales through September, shows that the average price for single-family homes has declined 19 percent since last year. Since June of 2006, when the home price index crested, values have declined 23 percent.

Boston has fared better. Home prices have fallen 11 percent since the peak of summer 2006, as measured by the S&P/Case-Shiller index. A separate barometer of home sales in Massachusetts, Warren Group's tracking of median home sales, shows a 23 percent decline since the peak.

Meanwhile, the S&P 500 index is down more than 40 percent for just this year. Of course, how these losses are felt depends on personal circumstances, such as local housing market conditions, how diversified one's portfolio is, and how far away one is from retirement and the need to tap long-term investments. To be sure, the fallout from the ongoing economic crisis will affect all Americans to varying degrees.

Meir Statman, a behavioral economist at Santa Clara University, said he believes the crisis may jar Americans into returning to more traditional notions of what investing in a home means.

"Just knowing what I know from the past, surely homeowners and investors are chastened by what has happened. I think it's easier now to preach caution and prudence than it was in late '90s for stocks, or '03 to '05 for houses. Back then everyone was saying the sky's the limit, despite previous busts. Hopefully this lesson will stay a bit longer."

William Robbins, a Boston-based financial planner, deals with clients stunned by the one-two punch of sinking home and stock values on a regular basis. He said he doesn't sugarcoat it.

"We saw tremendous wealth go out the window during the Internet bubble, but other sectors were still doing well, and people overall were optimistic," he said. "What we see now is a lot of sectors across the board doing poorly. There isn't much optimism."

At the same time, Robbins tells his clients, the sky is not falling.

"America has been through a lot of cycles. I don't think the world is coming to an end," he said. "There'll be another engine to drive the market higher and higher."