February 2012 |
|---|
Despite a stock market rally that has taken some market indices to recovery highs, participation in the market by individual investors has remained lackluster. These investors, especially the baby boomers, surprisingly continue to use this upturn in stock prices to actually reduce their exposure to the stock market. Studies have shown that demographic trends help explain this behavior and these trends could cause a significant headwind for future equity returns.
According to the Investment Company Institute, there has been a lot of money coming out of equity mutual funds since the summer of 2009. The selling seemed to pick up on market rallies. Most surprising was the constant heavy selling of equity funds last year from May through December. During those eight months $168 billion dollars flowed out of stock funds.
During that same period, from April 2009 through December 2011, there were only 4 months out of 33 where net money flows were negative for bond funds. Those few negative flows were extremely small in comparison to the substantial monthly amounts consistently flowing into bonds.
Most market commentators point to the fear of stocks that has grown in the hearts and minds of individual investors over the last decade. Experiencing two severe bear markets in 10 years and having very little, if anything, in gains at the end is understandably disheartening.
In addition, the extreme volatility in the stock market over the last two years would also explain investors’ trepidation for investing in stocks. This was definitely “no market for old men”!
In fact, it is my contention that a major reason why the net money flows have been leaving equity funds and flowing into fixed income funds is because of the shifting demographics of the U.S. population.
It is rational behavior to want to reduce risk in one’s retirement portfolio as one gets older, especially when retirement is just a few years away. Investment losses are not so easy to recover when a person begins to live off of those savings. That is why I believe many baby boomers have been using the market recovery to reallocate their portfolios to less volatile investments that focus on income instead of capital gains.
Unfortunately, there are consequences for future expected market returns because of this shift in portfolio allocations by such a large demographic group. What the baby boomers gave the market in the 80’s and 90’s, they are now taking away!
Last year I read an August 22, 2011 study that was conducted by Zheng Liu and Mark M. Spiegel of the Federal Reserve Board of San Francisco. The paper’s thesis was that the outlook for the U.S. stock market over the next 10 years is not very good because of the retiring baby boom generation.
We are all aware that the baby boom generation 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 prices from the mid- 80’s when they entered their peak earning and savings years.
It is also logical that as the baby boomers began to approach retirement in the past decade, they became more conservative with their investments. According to the authors, this age-based portfolio rebalancing has contributed to the decline in valuations for stocks since 2000.
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 S&P 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. 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 aged, both the M/O ratio and the P/E ratio 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% 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 the year 2030. It was not encouraging for investors who are hoping for a new secular bull market sometime soon.
According to their model, Lui and Spiegel found that the P/E ratio for the S&P 500 Index should decline from about 15 in 2010 to about 8.3 in 2025. At that time, this demographic headwind will finally turn into a tailwind.
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 real rate of 3.42% (that is, prior to inflation), then the stock market (again, stripping out inflation) is expected to be in a downward trend until the year 2021. The estimated cumulative inflation-adjusted decline is 13% during this span of time.
The “good news” is the demographic trend turns positive around 2025 so the authors expect a strong bull market at that time. By their calculations, the inflation-adjusted value of stocks will be 20% higher in 2030 than they were in 2010.
There are clearly 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.
We shall see if this time is different.
