All Bearish for Financial Assets. Do not be scared, survive.As 401k return diminish, where will housing go?
Demographic Trends Show Another Lost Decade Ahead
Inquiring minds are digging into a Federal Reserve Bank of San Francisco report that models equity prices and P/E ratios based on demographics. The outlook is not promising to say the least.
Interestingly, the report matches articles I wrote earlier this year based on cycles, not demographics.
First let's take a look at the Fed report, then another look at my previous articles on P/E expansion and contraction followed by a new chart that suggests another "lost decade" is in progress right now.
Please consider Boomer Retirement: Headwinds for U.S. Equity Markets?
Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.
Demographic trends and stock prices: Some evidence
To examine the historical relationship between demographic trends and stock prices, we consider a statistical model in which the equity price/earnings (P/E) ratio depends on a measure of age distribution.
We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio.
Figure 1 displays the P/E and M/O ratios from 1954 to 2010. The two series appear to be highly correlated. [Circles added by Mish for later reference]
Between 1981 and 2000, as baby boomers reached their peak working and saving ages, the M/O ratio increased from about 0.18 to about 0.74. During the same period, the P/E ratio tripled from about 8 to 24. In the 2000s, as the baby boom generation started aging and the baby bust generation started to reach prime working and saving ages, the M/O and P/E ratios both declined substantially. Statistical analysis confirms this correlation. In our model, we obtain a statistically and economically significant estimate of the relationship between the P/E and M/O ratios. We estimate that the M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.
Demographic headwinds for U.S. stock prices
This evidence suggests that U.S. equity values are closely related to the age distribution of the population. Since demographic trends are largely predictable, we can forecast the path that the P/E ratio is likely to follow in the next few decades based on the predicted M/O ratio. Figure 2 compares the actual and model-implied P/E ratios for the sample period ending in 2010. We calculate the path for the model-implied P/E during the sample period by feeding in actual M/O ratios. We call the long-run path of the P/E ratio predicted by the model the “potential P/E ratio” and designate it P/E*. Figure 2 shows that the P/E* (red dashed line) is highly correlated with actual P/E during the sample period.
To generate a forecast for actual P/E from 2011 to 2030, we must first project P/E* for that period. To obtain this future P/E* path, we calculate the projected M/O ratio from 2011 to 2030 by feeding Census Bureau projected population data into the estimated model. Figure 2 shows that P/E* should decline persistently from about 15 in 2010 to about 8.4 in 2025, before recovering to 9.14 in 2030.
