Common Factors Influencing the House Market and the Stock Market

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Accumulated Wealth of American Households

The topic is of great importance if stocks and houses are large components of the total wealth among American households. The topic is still important to investigate even if this is not the case since a change in one of the two markets might predict changes in the other. Investigating the balance sheet of American households provides information of their exposure to the stock market and the house market. The examination shows the percentage of total wealth consisting of stocks and houses. The original data was retrieved from the Board of Governors of the Federal Reserve System (2013).

Comparision of the Stock Market and the House Market

By plotting the two indices in one figure it will be possible to compare them. A graphical examination of historical movements may indicate a relationship. Moreover it will reveal whether the relationship between house prices and stock prices have remained consistently positive, negative or nonexistent. A period with a significant change in the relationship could indicate a structural break. In order to be able to compare the two indices they need to be standardized. The normalized index values5 are calculated and plotted in figure 3.

Research Focusing on Correlation Analysis

The correlation between two assets is a significant factor affecting investment decisions. The term correlation refers to how assets move in relation to one another. A high correlation is associated with a high level of risk. A common objective among investors is to strive after achieving the lowest possible correlation. The correlation between houses and stocks has been examined by several authors and the results are mixed. Quan and Titman (1999) conducted a time series study in 17 countries6 with data from 1984 to 1996. In addition to stock prices and real estate prices, their model also included GDP, interest rates and inflation as control variables.

Wealth Effect

The wealth effect suggests that changes in asset prices affect the net wealth of households, which in turn influences their consumption (McDowell et al. 2012). As concluded previously, stocks and houses are a large share of the net wealth of households and changes in the value of both of them should influence consumption. This theory holds if houses are assumed to be a consumer good. The price of consumer goods, and thus houses, is determined by demand and supply. Since it takes time to construct new houses, the supply of houses is assumed to be fixed in the short-run. An increase in demand for houses is therefore assumed to boost house price.

Modern Portfolio Theory

Modern portfolio theory, introduced by Markowitz (1952), focus on the expected return and the expected variance (risk) of a portfolio. The objective is to maximize the expected return, given a predetermined variance or to realize a predetermined expected return with the lowest possible variance. The theory emphasizes that the investor should evaluate the asset´s contribution to the portfolio´s overall risk and return rather than evaluating each asset individually. By looking at the overall contribution it is possible to control for a desirable level of expected return and expected variance. To achieve this, the investor 20 puts different weights to the assets in the portfolio depending on his/her objective (Elton et al. 2011).

Credit-Price Effect

A unidirectional causality running from the house market to the stock market exist if the credit-price effect is present. A large part of the majority of firms´ balance sheets consists of real estates. A change in the value of real estates should therefore have a significant impact on the value of firms and thus its stock price. Changes in the value of real estates do also influence the creditworthiness of firms. An increase in the value of the real estates increases the creditworthiness of firms and they can borrow more money and thus invest more. These investments should increase the performance of the firm, implying that cash flows and thus the stock price appreciates.

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Size and Timing of the Causality

Many of the previous studies investigating the causality between the stock market and the house market do not provide information about the size and timing of the causality. This thesis will provide such information and the best way to gain information of the size and timing of the causality is to look at the few previous studies available investigating the issue. Sim and Chang (2006) found a unidirectional causality running from the house market to the stock market. They used a generalized impulse response function to test how the stock market reacted to shocks in house prices and land prices in Korea. They concluded that the stock market reacts immediately to shocks in house prices and land prices. Ibrahim (2010) examined the relationship in Thailand and concluded that the stock market caused the house market.

Interest Rate

Investments, such as stocks and houses, are highly affected by the interest rate. The risk free rate is often the benchmark for returns of more risky investments. The level of interest do also affect the present value and it is therefore important to take it into consideration before making any investment decisions. Interest rates and asset returns should have a positive relationship according to the capital asset pricing model (CAPM). According to the CAPM, investors hold only two types of assets, risky assets (such as houses and stocks) and riskless securities. The investor combines these two types of assets in order to achieve a desirable risk-return distribution. In equilibrium, the return on an efficient portfolio is determined by the market price of time and the market price of risk multiplied by the exposure to the risk (Elton et al. 2011).

Table of Contents :

1 Introduction
2 Background
- 2.1 Accumulated Wealth of American Households
- 2.2 Historical Stock Market Movements
- 2.3 Historical House Price Movements
- 2.4 Comparision of the Stock Market and the House Market
3 Previous Research
- 3.1 Research Focusing on Correlation Analysis
- 3.2 Research Focusing on Causality
4 Theoretical Framework
- 4.1 Causal Relationship
  - 4.1.1 Wealth Effect
  - 4.1.2 Modern Portfolio Theory
  - 4.1.3 Credit-Price Effect
- 4.2 Size and Timing of the Causality
- 4.3 Common Factors Influencing the House Market and the Stock Market
  - 4.3.1 Interest Rate
  - 4.3.2 National Income
- 4.4 Hypotheses
5 Data
- 5.1 Stock Market Index
- 5.2 House Price Index
6 Empirical Design
- 6.1 Descriptive Statistic
- 6.2 Bivariate Correlation Matrix Analysis
- 6.3 Granger Causality
  - 6.3.1 Assumptions
  - 6.3.2 Vector Autoregressive Model
- 6.4 Granger Causality: Stock Market and House Market
- 6.5 Granger Causality Including Control Variables
- 6.6 Granger Causality Allowing for Structural Breaks
  - 6.6.1 Period 1:
  - 6.6.2 Period 2: 2003-2013Q
- 6.7 Impulse Response Function
- 6.8 Practical Implications
7 Conclusion
- 7.1 Suggestion for Further Research and Improvements
- References
- Appendix