On Road to Recovery, Stocks Wait for Real Estate

Consider real estate to be the missing link in the stock market recovery.

The subprime mortgage collapse and credit crunch have combined to soften stock rallies and blunt trading volumes, and many on Wall Street believe the market won't stabilize until it can do it on the shoulders of a real estate recovery.

AP

And the resuscitation of real estate could take a while, despite efforts by the Federal Reserve to lower interest rates and encourage borrowing.

"All signs are pointing to the housing market remaining weak for at least 2008 and into 2009. We'll likely see home prices fall in mid-single digits across the country," said Mike Larson, an analyst at Money & Markets. "Sorting through the credit mess, we're eventually going to restore some demand. As we get into '09, that will start to increase and the market will improve."

Housing numbers have indeed been weak, and even the National Association of Realtors predicts a soft market at least through the first half of 2008. The organization's Pending Home Sales Index has been slipping consistently, down 17.3 percent year-over-year in December, and the aggregate home price is expected to drop 1.2 percent for the remainder of this year.

The housing industry received a dose of optimism Tuesday as the National Association of Home Builders confidence index showed an unexpected gain in February, but the metric is still mired at near-historic lows.

There are many culprits in the story of housing's decline, but one trigger was a rise in housing prices that in some areas outstripped the growth in income. As property values fell, borrowers with high loan-to-value ratios found themselves in a negative equity situation, in which they owe more on their homes than they are worth.

That has meant, among other things, a decline in home equity borrowing, which was also spurred by the tightening of loan restrictions among banks -- a factor contributing to the broader economic slump. That also has thwarted the effectiveness the Fed interest rate cuts.

"What we're seeing is money has become cheap but unavailable," said Art Cashin, director of floor operations at UBS Financial. "You walk in to borrow it, nobody wants to lend it to you, but the price in the window is cheaper than it used to be."

A pullback among home prices to more affordable levels could kick-start the industry's resurgence. Rate cut proponents say the real benefits from dropping interest rates kick in afterward.

"Despite what's going on in the very short term, over the very long term these Fed rate cuts should help restore market health," Larson said. "As prices fall, it will bring some of these price-to-income ratios back in line, to find a meeting point where people can afford a traditional home with traditional means and traditional financing."

In that vein, not everyone thinks it will take the entire year for housing to recover.

Some believe that once the Fed's moves kick in -- conventional wisdom is that it takes about six months for a rate cut to take hold -- more and more people will begin wading back into real estate.

"People need to feel better. That's inevitable. Every cycle you go through these periods," said Bill Isaac, managing director at LECG in Vienna, Va., and former chairman of the Federal Deposit Insurance Corp. "When we were in a boom trade, nobody thought housing could go anywhere but up. We're on the other side of that slope now."

Moreover, Isaac believes financials are not in as bad a shape as some suggest. As evidence, he points to the relative ease with which Citigroup and others hammered by bad subprime bets have replaced the capital they lost in mortgage writedowns by raising money from investors around the world.

He also cited beleaguered lender Countrywide Financial , the leading US mortgage company, which saw its stock in freefall but was then snapped up by Bank of America .

"I see some large problems that are causing institutions some headaches and pain, but I also see some institutions that are working through it pretty easily," Isaac said.

© 2008 CNBC.com