(FORTUNE Magazine) – The signs of recovery are so obvious that only an Olympics figure-skating judge could miss them. The manufacturing sector rebounded in February after an 18-month-long tailspin. Activity in the all-important services sector has now accelerated to its fastest pace in more than a year. Productivity growth has just been revised up to 5.2% for the fourth quarter, a level that's causing 1990s flashbacks. And on the jobs front, employment grew for the first time in seven months. Even capital spending, a longtime trouble spot, seems to be reviving. In fact, the news has been so good that Alan Greenspan, our famously cautious, usually indecipherable Federal Reserve chief, recently proclaimed in plain English: "An economic expansion is already under way."

So is that it? Have we just had something like a 15-minute recession, and is it all smooth sailing from here? Not so fast, says a chorus of economists--plenty can still go wrong. Leaving aside such nightmare scenarios as further terrorist attacks, all-out war in the Middle East, or an oil embargo, the thing that spooks some economists the most is housing. That's because while the economy has been on the down escalator over the past several months, the property market has been going in the opposite direction, and that's just not supposed to happen.

In fact, housing didn't just hold its own during the slump. It zoomed. Activity has been so strong that sales of new and existing homes hit all-time records last year. Not exactly what you'd expect when around two million people were losing their jobs, is it? What's more, we've seen record growth in mortgage refinancing, and annual home-price increases between 6% and 8% nationally for three years in a row. "That's unsustainable by any measure," says David Levy, chairman of the Jerome Levy Forecasting Center. "Especially now that mortgage rates are on the rise." And that's the problem, according to Levy and others. The one sector we've relied on to keep the economy afloat is unlikely to hold up much longer. Worse still, housing could even turn out to be the next bubble--and we all know how that usually ends.

So are the worrywarts right? Probably not, but it's certainly worth hearing them out, because even if they're a little right, a weak housing market could help make this recovery pretty darn anemic. There are already signs that housing activity is starting to cool. For the first time in seven years, national home prices fell in the last three months of 2001, by 1.9%. The market for second homes has also weakened since the end of last year. And some banks are tightening up on their mortgage lending. Ken Hackel, chief fixed-income strategist at Merrill Lynch, says one major bank has admitted to recently changing the rules on refinancing, requiring appraisals on every application regardless of whether one had been done in the past year--a telling sign that some lenders expect home values to soften. True, January sales remained incredibly strong, but economists argue that those numbers were probably exaggerated by the unseasonably warm winter across much of the nation.

Certain regional markets may already be in trouble. According to data from Case Weiss Shiller, home prices in San Francisco have been dropping precipitously. In the first quarter of 2001 the average price of a single-family home there rose 4%, but by the end of the year had fallen 7%. "We're seeing a bubble bursting right now in San Francisco," says Robert Shiller, an economics professor at Yale University and partner at Case Weiss Shiller. "We've never seen such a sharp drop, and we're expecting it to fall even more." Shiller, who warned of a stock market bubble in the late 1990s and coined the phrase "irrational exuberance," believes there's the risk of a housing bubble in other major cities. At the top of his watch list are Portland, Ore., Seattle, Denver, and New York.

If you thought the tech bubble's bursting was bad for the economy, just imagine what a housing bubble could do. Around two-thirds of households own their home, while only half have exposure to the stock market. That means the wealth effect we heard so much about during the 1990s is even more pronounced when it comes to housing--in fact, according to a study by Shiller and a colleague, it's twice as large. A 10% increase in home values, for instance, would result in a 0.6% increase in consumption, they found, while a 10% increase in stock prices would lead to a 0.3% increase in spending. "People see their home as a source of wealth," says Shiller, "so they haven't felt the need to save. That's sustained our high level of consumption, but it's made the economy more vulnerable."

How did we get here? Simple: Interest rates on 30-year mortgages have fallen from a peak of 8.7% in May 2000 to a low of 6.5% in November 2001. That sharp drop encouraged a record wave of refinancing even as the economy slowed down. Douglas Duncan, chief economist at the Mortgage Bankers Association, calculates that so far households have taken out at least $80 billion in equity after refinancing their mortgages. From that total, he estimates $50 billion has been spent and $30 billion used to pay off debt. It's that extra $50 billion in consumer spending that has kept the economy from sinking further in this downturn. (To put that number in perspective, $50 billion is about the same size as President Bush's 2001 income-tax cut.)

While that's been a boon for the economy, it could have unpleasant consequences in the long term. Never before have consumer debt levels been as high as they are now. Total household debt stands at $7.4 trillion, almost double what it was at the beginning of the 1990s. In part that's because more people are buying homes, but it's also the result of the refinancing boom, which has encouraged households to borrow more against the increased value of their home. "Debt is fixed, while asset values aren't," says Levy. "If we have a sharp weakening in the housing market as we did in parts of the country in the 1980s and 1990s, suddenly all that leverage causes problems for consumption and lending." And debt as a percentage of home asset values has been steadily increasing. In the early 1990s, mortgage debt to home values stood at 35%. Today it has jumped to 45%.

That's why economists like Levy and Shiller are worried about a housing bubble. They see it playing out like this: As interest rates rise, housing becomes less affordable and demand slows. As demand slows, prices can't be sustained and may even fall, as they have in San Francisco. Then, as home prices stagnate, owners cannot tap into equity gains and borrow money, so they curtail their spending. Worse, households with high debt levels may find it increasingly difficult to sustain mortgage payments, leading to more homes on the market and further price declines.

The housing bubble theory relies on one of two things happening. Either interest rates have to rise high enough to choke off demand or some other factor must reduce our appetite for real estate. And in today's volatile world, it's not hard to imagine some sort of shock to the property market--the U.S. entering a war with Iraq, say. That could prove a big enough blow to consumer confidence to dampen demand for homes and lead to a huge drop in prices.

So how can you tell when there's a bubble? One sure way is to wait until it bursts and see how far prices plunge. But by then, of course, it's too late to do anything about it. Another is to monitor the market for signs of speculative behavior. Craig S. Davis, president of Home Loans and Insurance Services at Washington Mutual, explains his trusty bubble test. "First, you get a lot of cocktail chatter. Everyone's talking about how much money they're making on housing," he says. "Then you see multiple bids and offer prices jumping above asking prices. That's when you have a bubble." But Davis says he doesn't see any evidence of that kind of activity right now. Nor is he worried about a housing bubble around the corner.

For Davis and other home lenders, the exceptionally strong housing market has been driven by solid fundamentals, not speculation. The drop in mortgage rates to a 30-year low, growing real disposable income during the downturn, an increase in the number of households across the country, and new mortgage products like hybrid adjustable-rate loans go a long way toward explaining the housing phenomenon. Economists like Christopher Wiegand at Salomon Smith Barney also emphasize that the supply side of the equation doesn't at all resemble a bubble. Normally, in past housing bubbles such as the one in the late 1980s, supply from overbuilding flooded the market. Today, the supply of homes is at its lowest level since the early 1970s. "Many builders have had to finance their capital through the markets and banks, which have been guarded," he says. "As a result you haven't seen a big speculative burst in residential construction."

Perhaps most reassuring of all, while prices have risen consistently in most regions across the country, they haven't risen nearly as much as during the last housing bubble. For instance, look at Massachusetts. In the past three years home prices have averaged a 12.6% annual increase, while during the mid-1980s they averaged 23.3%. The story is much the same in areas like California, where prices seemed totally insane in the late 1990s. During the past three years home prices have increased at an average annual rate of 11.3%, compared with 16.7% at the height of the late-1980s bubble.

There are other encouraging signs too. Delinquencies, which started to rise last year, have turned down again more recently. According to the Mortgage Bankers Survey, delinquencies fell in the fourth quarter and remain at a fairly low level. The most encouraging news is that the job market has finally started to recover. Jobless claims have been falling for several weeks in a row now, and the latest employment report, for February, showed that 66,000 new jobs had been created. And though economists expect unemployment to continue to creep up this year, the consensus is that the worst of the layoffs is probably behind us.

As long as inflation remains subdued, interest rates should also stay low, and that's good news for the housing market too. While rates for 30-year mortgages have already started rising and are currently around 7%, most economists are forecasting limited gains this year. David Berson, chief economist at Fannie Mae, expects mortgage rates to remain between 7% and 7.5% for the remainder of the year. Other economists, like Salomon's Wiegand, believe they could go a bit higher but not above 8%.

So where does that leave the housing market? Even mortgage lenders who are optimistic about the market expect activity to slow this year and price gains to be more modest. Duncan from the Mortgage Bankers Association expects average home prices to rise by 2% to 4% in coming years, rather than the 8% rate we've been seeing. Hackel from Merrill Lynch agrees. "Normally, we get a ramp-up in housing prices and then a long flat period," he says. "I think prices will be flat for the next three to five years."

Obviously, that won't do much for what already promises to be a sluggish recovery. Of course, if the worriers are right and the housing market collapses, we won't have a recovery at all. But with a bit of luck, the sector will cool down in an orderly fashion--and, economically speaking, we've been rolling a lot of sevens recently.

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