There is a paper making the rounds from the FRBSF that looks at the predictive relationship between "middle" savers (40-49) and "old" spenders (60-69) for equity market P/E ratios. The paper demonstrates a relationship between the M/O ratio and historical market P/E ratios from 1954-2010. The paper is a quick read.

The conclusion that is getting the attention reads:

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.

A couple of quick points on the FRBSF economic letter:

1) The key paragraphs in terms of stock implications are:

Since we have forecast a path for the P/E ratio, predicting stock prices is straightforward if we can project earnings, the E part of the ratio. For this purpose, we assume that, in the next decade, real earnings will grow steadily at the same average 3.42% annual rate by which they grew from 1954 to 2010. To obtain real earnings, we deflate nominal earnings by the consumer price index.

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. The subsequent recovery is quite slow. Indeed, real 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.

Note that they are using "real" stock prices. Converting this to nominal using currently depressed inflation expectations of 2.01% over the next decade (from TIP breakevens) implies an increase in stock prices that is roughly 50% higher than what is priced into long-term S&P options. If they are right (and I think they are wrong), then the returns to equities using long-term options should be around 3.7% over the next decade (better than government bonds) while the returns to holding the S&P should be roughly the same 3.65% due to dividends received over the next decade.

They are also making an assumption that trend earnings growth mimics that of 1954-2010. They are calculating this using a straight line two point growth. Fortunately, they ignore that 1954 earnings were roughly 50% above long-term trend lines while 2010 earnings are roughly 30% below trend. Using an actual trend line (rather than point to point) growth would imply that S&P earnings should grow 10% per year over the next decade (this makes more sense if you forget about "peak margin" nonsense and recognize the current profit levels are against a very depressed economic output line). Using their other data (dubious for reasons articulated above and below) and trend earnings would imply the S&P should rise roughly 83% over the next decade (to ~2,100). This would yield returns from long-term options of 22.3% per year over the next decade while holders of the S&P should receive returns of 8.1% per year.

2) They "fit" data from 1954 to 2010. There is a reason for this choice of data sets — it's the only one that works. The demographic data offers zero explanatory power for periods prior to 1954 for one very simple reason — the proportion of the population that was aged 60-69 (their "old" people who are supposedly liquidating assets) was far, far lower. This would imply that P/E ratios should have been stratospheric in the pre-1954 period. We can see a tease of this in their chart that shows rising P/E ratios from 1964-1954 on their "model generated" line. Pre-1954, this model generated P/E would have risen dramatically. In contrast, they were depressed. As a result, I would strongly question whether we can generate any real insights on the forward direction of P/E ratios from this analysis.

The reality of all this nonsense is that when equity markets are low and falling, most people will offer explanations for why they are low and falling. Those arguments will sound intelligent until equity prices begin rising inexplicably. Then they will rage against the "bubble" until they suddenly see the light and argue we are at a permanently higher plateau.

Kim Zussman writes:

This is a variant of the "sell to whom" question posed by Jeremy Siegel in "Stocks for the Long Run". ie, when boomers retire and they change from saving to consumption, who will buy their stocks?

Siegel's suggestion was younger people of developing nations / emerging markets. Given the known tendency for people to invest closer to home, why wouldn't up and coming Indians and Chinese buy domestic vehicles rather than SPY?

Jason Ruspini writes: 

Whatever problems we think we see with such studies, it is an embarrassment for economics that the effects of demographics, globalization, and diffusion of technologies are not more widely studied and understood. This provides cover for all sorts of claims like "tax rates were higher in 1950 and 1990 and we had excellent growth then…"

Russ Sears adds:

While I agree that studying the effects of the predictable real economy on the real economy should get more study. Further I agree with your implication, that jumping from fiscal/monetary policy to real economy often hides a large amount of nonsense. However, I can not encourage a tunneled vision approach of narrow real effect to narrow real effect. Especially when I see the design of the study to be such that its intent is to keep people from following their natural ambitions and make sure the individual is smaller than he needs to be by discouraging investing in capitalism. They (the govt) only do these studies when this is the case. The nonsense comes by narrowing the line of vision to reach the conclusion that we need them to protect us from ourselves.

Jason Ruspini replies:

This sort of criticism was behind some of the controversy with Tyler's Cowen's book. To those on the right it sounded dangerously like " 'We' should do something! " To those on the left, " 'We' are poor and can't do anything…"

But I don't see why low average rates of return should discourage entrepreneurs. Situations like Apple and Facebook suggest that where there is growth in a low growth environment, money funnels to the innovators just the same if not more vigorously. Regarding Facebook, my sense is that part of the "problem" with current technologies as compared to those of the 19th-20th century is that the latter often compressed time in terms of more efficient communication, travel and production while the former largely serves to fill time with questionable effects on production and average asset returns. Additionally, the diffusion of the latter 20th century type across the world is now past its inflection point.

One other point..

Japan in the '80s through present might be a better complement to the Fed study than the pre-1950s world as suggested in Mr. Green's original email. Equity returns aside, all things equal, more retirees should translate to lower rates. Given sovereign debt, I guess one should say lower real rates.

Russ Sears responds: 

The government is in competition with the private sector for capital…In the fiscal world should the retiriees give their capital to Government and let them continue to spend or should they give it to entrepreneuars and let them spend it.

In either case fewer real world projects will begin to those who loss the competition for capital. All things being equal if less money goes to the stock market, few projects are begun and cost of captial is raised. If they cannot get capital from issuing stock, they must issue more debt, real cost of borrowing goes up.

But if real demand for private sector goods are raised and fewer project in the private sector were funded, cost of loans will go up and the profits per $ in the stock market would also increase.

If more money goes to government, the more our government becomes addicted to the low cost of capital, and the more it spends on less and less productive projects.

Am I missing something?

Which do you think will raise the overall wealth the most? Would you believe a government study suggesting investing in the private sector is doomed to low real returns for decades?



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