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The house price disconnect

Pessimism about the global economy hasn't reached the UK housing market. Bank of England figures this week show that mortgage approvals for house purchase rose by 4.6 per cent in January, to a two-year high.

In fact, though, there's nothing new about a contrast between a buoyant housing market and depressed stock market. In the past 30 years, the correlation between annual changes in house prices and the All-Share index has been zero. The two have moved in the same direction sometimes - such as when they both slumped in 2009 - but just as often, they have moved in opposite directions. For example, in much of the 1990s, stock markets did well while house prices were weak, but in the early 2000s house prices soared as shares fell.

What we've seen in the past 12 months, with house prices having risen but shares fallen is therefore not unusual. But it is puzzling from a theoretical point of view. In theory, house prices and share prices should both depend on the discounted present value of future incomes. If we expect better economic times, or if interest rates fall so that future incomes are discounted less heavily, both house and share prices should rise. And both should fall if income expectations fall or interest rates rise. For these reasons, house and share prices should be positively correlated.

So why aren't they?

It's not because house prices are slower than shares to respond to economic news. They are, but even if we look at longer-term changes, the two markets still have a low correlation.

Nor is it because the stock market reflects attitudes to the global economy. So too should the housing market. This is partly because house prices can be dragged up because of buying by rich foreigners, but more because UK economic activity is closely correlated with global activity.

Instead, there are two other possible reasons for the disconnect between the housing and stock markets.

One is that both markets are prone to excess volatility: either can rise or fall too much. The bursting of the house price bubble of the late 1980s led to falling prices in the early 1990s, during which time equities did well. And the bursting of the tech bubble caused shares to fall in the early 2000s as house prices soared.

The other is that shares and housing depend on different incomes - wages for house prices (the Bank of Mum and Dad can only stretch so far) and profits for shares. This means the two markets can diverge if the shares of profits and wages in the economy diverge, or are expected to. This is no mere theoretical possibility. Economists at New York University have estimated that all the rise in US equities since 1980 is due to a shift in incomes from wages towards profits.

The former explanation implies that house prices might be rising because they are in a bubble - the ratio of house to share prices is now well above its 30-year average - or that shares are underpriced.

The latter, however, has a very different implication. It could be that house prices are doing well because the wisdom of crowds anticipates a shift in income from profits to wages: this might occur through economic channels, as profits are squeezed by near-full employment, or political ones.

How worried equity investors should be by this prospect hinges on that persistent old question: are market participants rational or not? If they are, we should be concerned.