Wednesday, January 21, 2015

Stock Market Headwinds

In a recent posting, I looked at how demographic changes in the United States would have a long-term impact on housing prices.  As baby boomers who were large consumers of U.S. housing age and become net sellers of residential real estate, the supply of homes for sale will exceed the demand for those homes.  There is another little discussed asset class that could well see the same type of impact from an aging population.

As we have drilled into us by "investment experts", it is important to reduce the level of risk in our investment portfolios as we age.  Here's an example of what I mean:

An older investor is far less likely to want to risk a substantial portion of their assets in equities since, as we saw in 2008 - 2009, they can be extremely volatile.  One of the asset allocation by age rules of thumb states that you should take the number 100 and subtract your age to determine the percentage of your assets that should be in equities. 

A recent Economic Letter by Zheng Liu, Mark Spiegel and Bing Wang of the Federal Reserve Bank of San Francisco suggests that demographic patterns have a strong historical relationship with U.S. equity values; this relationship shows that the ratio of people who are at the prime age to invest in stocks to those that are at the prime age to sell stocks has historically proven to be a strong predictor of U.S. equity values as measured by price-to-earnings (P/E) ratios.

In their analysis, Liu et al measure the age distribution using the ratio of "middle age" people (M) who are between the ages of 40 and 49 years, the age group that is most likely to buy stocks, and "old age" people (O) who are between the ages of 60 and 69 years, the age group that is most likely to sell stocks.  This is called the M/O ratio.

Here is a figure showing the M/O ratio for the Group of Seven nations from 1954 to 2010 along with projections to the mid-2020s:

You will notice that in all cases except Japan, the M/O ratio is expected to drop over the next decade.  More specifically, the M/O ratio for the United States is expected to drop from 0.76 in 2013 to 0.60 in 2024, the ratio for Canada is expected to drop from 0.82 in 2010 to 0.53 in 2024 and the ratio for Germany is expected to drop from 0.90 in 2010 to 0.48 in 2024.  In the case of Japan who already has the world's oldest population, the M/O ratio is expected to rise slightly over the next decade as the size of its old-age cohort falls and then drop back to its current level.  

For the P/E ratio data, the authors used Bloomberg's end-of-year price data for the S&P 500 and the average earnings per share over the previous 12 months.

If we plot P/E versus M/O for the United States, this is what we find:

There is a strong positive relationship between high M/O ratios and high P/E ratios for the U.S. stock market.  This suggests that returns in the stock market correlate negatively to an increasing percentage of older people in the United States.

Here is what the P/E versus M/O for Canada looks like:

In the case of the markets in France and the United Kingdom, the positive relationship between higher M/O ratios is less clear (i.e. it is statistically insignificant) and in the case of Germany, Italy and Japan, the relationship is flipped (i.e. as the M/O ratio drops, P/E rises).  While the authors do not explain this contradiction, they do note that the integration of the world's stock markets means that they tend to act in tandem.  Since the U.S. stock market makes up around one-third of the world's total stock market value, it is obviously the market that sets the trend for the rest of the world's markets, a factor that became quite apparent during the stock market massacre of 2008 - 2009.

According to the author's analysis, the drop in the U.S. M/O ratio over the next decade suggests that the P/E ratio in 2025 will be half of what it was in 2013.  Of course, there are other factors that could impact stock prices including increased purchasing of U.S. equities by Chinese citizens, increased growth in productivity and U.S. investors holding on to equities further into their lives as life expectancy increases.

In any case, this analysis suggests that like other asset classes, the U.S. equity market may not be immune to the impact of an aging and risk-adverse population.

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