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Demographics work against the US stock market

22 Aug 2011 by Jim Fickett.

Demographics probably have had, and will probably continue to have, an influence on stock market valuations. This is because middle-aged people save up for retirement, and older people spend their savings. The correlation between a simple demographic variable and US stock market P/E suggests a longer-run P/E of about 9, much less than most investors assume.

Today Zheng Liu and Mark Spiegel at the Federal Reserve Bank of San Francisco published a short note on demographics and the US stock market, entitled Boomer Retirement: Headwinds for U.S. Equity Markets? There have been many studies along the same lines, suggesting that as the boomers retire and cash in their investments to provide retirement income, it will reduce demand for, and hence prices of, US equities. This particular study is very elegant in having an extremely simple measurement that provides high explanatory power.

The idea is quite simple. People in their 40s are in prime savings mode, and people in their 60s are beginning to use their accumulated savings (as well as to switch from stocks to bonds). So the demographic variable considered is simply the ratio M/O of the number of those 40-49 (M) to the number of those 60-69 (O). This ratio is compare to the standard price earnings (P/E) ratio as a measure of demand for equities (S&P 500, adjusted for inflation).

The historical correlation is striking:

Looking forward, the age structure of the population has been estimated for the coming decades by Census, so one can project M/O forward. Then, taking a best estimate of the relationship in the first graph, one can project P/E. Here is a graph showing actual (blue solid) and modeled (red) P/E. The red dashed line is the model's projection of future P/E (the blue dashed line is for a second model).

To the extent that demographics have, and will continue to, influence stock market valuations, this suggests a long-term P/E of about 9. Keep that in mind next time someone is project equity returns based on typical P/E's of, say, 15.