Opinions Investor's Corner Age wave headwinds for future stock market returns
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Investor’s CornerBy John Gudritz CFA
Principal
Front Street Investment Management LLC
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In my May 31 Investors’ Corner column, “Immigration Will Keep U.S. Young” I discussed the economic ramifications of the coming age-wave in Europe, Japan, China and, to some degree, the U.S. after 2020. Investors need to be aware of the long-term implications of that serious issue.
I recently discovered another challenge for investors of aging countries. According to a recent study conducted by Zheng Liu and Mark M. Spiegel of the Federal Reserve Board of San Francisco (FRBSF) and published in the Aug. 22 issue of the FRBSF Economic Letter, the outlook for the U.S. stock market over the next 10 years is not good and it is because of the retiring baby boom generation.
We are all aware that the baby boom generation, those people born between 1946 and 1964, has had a significant impact on the financial markets as they worked, saved and invested for retirement. There is no doubt that the increased demand for stocks and bonds from this generation helped boost valuations (i.e., price/earnings ratios) and prices from the mid 1980s when they entered their peak earning and savings years.
It is also logical that as the baby boomers began to retire in the past decade, they became more conservative with their investments and began to sell more risky assets like stocks and favor higher income and “safer” securities like bonds. This action has tended to depress valuations for stocks.
Liu and Spiegel examined the historical relationship between demographic trends and stock prices by creating a statistical model “in which the equity price/earnings (P/E) ratio depends on a measure of age distribution. [They] constructed the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and the average inflation-adjusted earnings over the past 12 months. [They] measured age distribution using the ratio of the middle-age cohort, age 40-49, to the old-age cohort, age 60-69. [They] called this the middle-aged/old-age ratio or M/O ratio.”
The authors used data between 1954 and 2010 and found the two data series, P/E ratios and M/O ratios, to be “highly correlated.” As an example, they showed that as the baby boomers reached their peak working and saving ages between 1981 and 2000 and the M/O ratio jumped from .18 to .74 (many more middle-aged than old people), the price/earnings ratio of the S&P 500 Index climbed from 8 to about 24. Then after 2000 as the baby boomers started moving into the “old-age cohort” and the much smaller baby bust generation became the middle-aged prime working and saving cohort, the M/O ratio and the P/E ratio both declined by a considerable amount. There was a “statistically and economically significant estimate of the relationship between P/E and M/O ratios.”
Liu and Spiegel estimated that the M/O ratio explains about 61 percent of the movements in the P/E ratio. They concluded that the M/O ratio predicts long-run trends in the P/E ratio of the S&P 500 Index.
The authors then used this model to forecast the future path of the price/earnings ratio of the S&P 500 Index out to 2030. It was not encouraging for investors who are hoping for a new secular bull market sometime soon.
Demographic trends in the U.S. are fundamentally predictable and provided by the U.S. Census Bureau. The authors used that data from the Census Bureau to compute the future M/O ratio. They then calculated the path for the model-implied P/E ratio that they called the projected P/E ratio.
What they found was that the P/E ratio for the S&P 500 Index should decline from about 15 in 2010 to about 8.3 in 2025. It will then “recover” to 9 in 2030.
That forecast for the future S&P 500 Index P/E ratio should be very disconcerting for investors. If you assume that the earnings for the S&P 500 companies grow at their historical average annual rate of 3.42 percent, excluding inflation, then the stock market, adjusted for inflation, is expected to be in a downward trend until the year 2021. The estimated cumulative decline is 13 percent relative to 2010.
If that wasn’t bad enough, the subsequent recovery is expected to be slow with real stock prices not returning to their 2010 level until 2027.
The “good news” is that the M/O ratio rebounds in 2025 so the authors expect a strong bull market at that time. By their calculations, the inflation-adjusted value of stocks will be 20 percent higher in 2030 than they were in 2010.
There are other factors that help drive stock prices like interest rates, inflation, productivity and earnings growth. Increased demand from foreign investors might have more of an effect in the future than in the past. However, this and other studies have shown that there is a direct and important correlation between demographic trends and long-term trends in stock market valuations and investment returns. Let’s hope that this time is different but let’s plan that it won’t be.