Demographic Blues

In Industry Illusions, Market Commentary, Retail, Retirement on

The Federal Reserve Bank of San Francisco published a fascinating piece of research on Monday relating U.S. stock market performance to demographic trends. The results are not encouraging for long-term ‘Buy and Hold’ type investors.

By Zheng Liu and Mark M. Spiegel

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.
Historical data suggests a strong relationship exists 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, Boomers are likely to shift from a bias toward saving and buying stocks, to selling their equity holdings to finance retirement. Statistical models suggest that this shift could substantially depress equity valuations over the next 15 years or more.
Without belaboring the mechanics of the study, the researchers analyzed trends in the proportion of middle-aged workers in the U.S. economy relative to the proportion of retired workers to forecast future stock market valuations. This research follows other studies which found that the booming markets of the 1980s and 1990s were largely attributable to the bulge bracket of baby boomers who were entering their prime saving and investing years during those decades.
In contrast, the current Federal Reserve study finds that, as the ratio of middle aged workers to retired persons is forecast to fall persistently through 2025 as the bulk of baby boomers retire, these same boomers will be withdrawing savings from stock and bond markets, thereby exerting slow but steady downward pressure on prices of financial assets, including stocks, for the foreseeable future.
The specific demographic ratio analyzed in the study is the M/O ratio, which is the population ratio of those aged 40 – 49 to those aged 60 – 69. This ratio broadly captures the number of people in prime saving and investing years relative to the number of people who are beginning to withdraw from savings to fund retirement. From 1981 to 2000 this ratio increased from 0.18 to 0.74 at the same time stock valuations rose from roughly 8 times earnings to almost 30, and the main U.S. stock market index exploded from 150 to almost 1500.

Sadly, the U.S. Census Bureau is forecasting exactly the opposite dynamic to play out over the next 15 years as boomers retire. As this demographic scenario unfolds, the Federal Reserve Bank’s model suggests that stock prices will enter a persistent decline until 2021. Further, stocks are not expected to exceed their 2010 levels until 2027, after adjusting for inflation.
Key findings:
  • 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.
  • Given the projected path for P/E* and the estimated convergence process, we find that the actual P/E ratio should decline from about 15 in 2010 to about 8.3 in 2025 before recovering to about 9 in 2030.
  • The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010.
  • Inflation adjusted stock prices are not expected to return to their 2010 level until 2027.
  • On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.

Source: Federal Reserve Bank of San Francisco
Interestingly, the conclusions from the Federal Reserve paper mirror the conclusions from our own proprietary ‘Estimating Future Returns‘ models, which suggest investors should expect near zero returns after inflation for at least the next 15 years.


Source: Shiller (2011), (2011), Chris Turner (2011), World Exchange Forum (2011), Federal Reserve (2011), Butler|Philbrick & Associates (2011)
While this outcome may appear inconceivable to many, I would urge you to examine the path of Japanese stocks from their peak in 1989 at almost 40,000 to their current price under 10,000. Japan suffered from too much debt and an unhealthy property sector, but these headwinds were amplified by another challenge which we in the West share (though not quite as badly): a declining share of working persons relative to retired persons.
Perhaps not surprisingly, U.S. stock markets have been tracking the performance of Japanese stocks since U.S. stocks peaked in 2000. When we overlay the two stock market indices and align their respective peaks, the resemblance is uncanny (and not a little bit shocking for ‘Buy and Hold’ investors). If we continue to track the Japanese experience, we may be setting up for another major drop, perhaps to new lows.

Source: Bloomberg,
You probably aren’t hearing this message from pundits on TV or in the papers, or economists at the major banks or investment firms. However, I urge you to keep three thoughts in mind when you hear these experts speak:
1. If a person’s job depends on them not knowing something, then they won’t know it.
2. Investment firms make much higher margins from clients who hold or trade stocks or stock mutual funds than from clients who hold bonds or cash instruments like GICs or money market funds. As such, they have a strong incentive to keep clients invested in stocks and stock mutual funds at all times, per the ‘Buy and Hold’ approach.
So what is a person to do when long-term Canadian bonds are yielding 0.64% after inflation, and developed market stocks are likely to yield no returns (but probably typically high volatility) for the next 15 years or more?
At Butler|Philbrick & Associates, we have a plan. At its core, our approach embraces two major areas of differentiation:
  1. Broaden the investment opportunity set for portfolios to include international and emerging market stocks, real estate, commodities,etc. Cash is an asset class!
  2. Apply a proven process to decide which asset classes to own (including cash when markets are risky), and when to own them.

As a proof of the effectiveness of our approach in difficult markets, we published a study on how to profitably trade the Japanese bear market back in February (see here for full study). We have suspected for some time that the Japanese template was the most likely trajectory for developed stock markets over the next several years.

In the study, we applied our trend following approach to the Japanese stock market to see how it would have performed over its 21 year downhill roller coaster ride.
Source: Butler|Philbrick & Associates
You can see in the chart that by taking advantage of both positive and negative trends using a simple timing system over this period, our technique delivered over 16% annualized investment performance, while never dropping more than 22.9% from any peak to trough (see “CAGR%” and “Max Total Equity DD” respectively in the table above the chart).
Pretty good results generally, but especially when they’re compared with the 75% cumulative loss that most Japanese investors experienced by holding stocks over the past 20 years.
We are following a proven trend following model like the one above to deliver prospective returns for clients no matter what happens in markets. What are you (or your Advisor) doing to prepare for this potential investment outcome?