Demographics and Stock Markets

Long term trends are very difficult to time, but cannot be ignored as a backdrop for cyclical and secular moves.Viewing the remainder of this article requires a Subscription

Boomer Retirement: Headwinds for U.S. Equity Markets?

I write about demographic issues periodically because their long term impact on money flows globally, regionally, etc. on every level is invaluable in determining long term trends.Viewing the remainder of this article requires a Subscription

Demographics

A few days ago, Mark Hulbert wrote a piece on MarketWatch.com that caught my attention: USA Will be Especially Youthful in 2020. I often write about demographics as one of the more predictable and powerful, yet least utilized, factors, and I was sure that by now, this research would have been picked up by more analysts. It hasn’t.

A quick summary: Hulbert points to research by Ned Davis Research that the proportion of children under the age of 15 will rise by 2020 to levels unmatched by any other developed nation except Ireland. Aside from being a long, long-term positive for Ireland, this will give the US distinct advantages in the future. But, and it’s a big BUT, this is a very long term demographic shift. What are the implications?

For starters, the immediate implications are to know that investors tend to not account for changes that are more than 5 years out, so this won’t be factored in by most investors for at least 3-5 years. Addressing just this issue, Hulbert writes:

Entitled “Attention, Demographics, and the Stock Market,” the study found that the market systematically does not take into account the consequences of demographic trends that are more than five years into the future — even when those consequences are quite predictable. (The study’s authors are Stefano DellaVigna, an associate professor of economics at University of California at Berkeley, and Joshua M. Pollet, an associate professor of finance at Michigan State University. Click here for a copy of the study .)

Another of the professors’ findings shows just how much is at stake: On average historically, they found, whenever demographic trends predicted a one-percentage-point increase in demand for an industry’s goods or services, its profits that year were 5% to 10% higher.

So even though 2020 seems like an awfully long way off, the rewards will be great for those who begin now to anticipate what the world will look like then.

The rewards for thinking and planning ahead will be great. The TradersNarrative blog picked up on Hulbert’s analysis and provided the following analysis:

A chart of the ratio of those middle-aged and those young has an unbelievably good track record for predicting the price earnings ratio of the stock market. And since the vast majority of the total return from the stock market comes from price earnings expansion, this provides us with a very good guide for future stock market returns. Of course, this is a long term and macro guide. It is not suitable for navigating the short-term gyrations of the market.

Here is a chart from a research paper written by Favero, Gozluklu and Tamoni illustrating the relationship between stock market returns and the MY ratio:

Source: Demographic Trends, the Dividend/Price Ratio and the Predictability of Long-Run Stock Market Returns

This would lead one to assume that the bear market has a few more years to go, with wild swings the norm. Additionally, it means that the areas most vulnerable might be luxury retail, high end restaurants, and large mcmansions. It’s also a long term benefit to companies geared towards the under 15 year crowd – from educational games, video games, and your local jungle gym manufacturer. For now, it confirms for me place I want to stay away from (luxury and “wants”) and places where I want to look for solid foundations in demand (“needs”).

Relevant ETFs: XRT, RTH, XLY, VCR, IYC, SZK

More on the yen – read this

For all I know, Keynesians might be even right in thinking policy makers can fiscally jolt economies back to life, allowing them to recover back to their ‘default mode.’ But their assumption is that ‘default mode’ is positive growth. But what if it isn’t? What if the ‘default mode’ is falling output because the population is declining? Japan might just have spent the best part of twenty years trying to fiscally stimulate its way out of a demographic compression. If this is correct, and population decline has blown the hole in Japan’s government balance sheet there’s still plenty of damage in store because the demographic compression isn’t over yet.

This is a must read article about the yen, assumptions, demographics from Dylan Grice at SocGen.

GS catching up on our conversations on demographics

We’ve often discussed demographics as a critical long (very long) term indicator – and, by the way, the message ain’t good. Goldman is finally catching up on the conversation. The main idea is that by looking at demographics, both on a national and world level, we can anticipate major trends in spending, real estate, and price pressures. For years, the developed world has known that it is facing a declining demographic profile brought on declining fertility rates and just the sheer size of the baby boomer generation. The emerging markets, meanwhile (except for China), maintained a younger average age, higher fertility rates, etc. Additionally, the savings profile in the emerging markets has helped sustain the overspending of baby boomers – and that was at the time when baby boomers were in a position to save on their own if they so chose, which they didn’t.

And now, the baby boomers are entering a phase of declining savings, and are facing structural challenges that will need to be financed. Goldman starts to analyze them. Here are the main highlights:

• Demographics are a major determinant of long-term current account trends.
• Countries with a high proportion of ‘prime savers’ (those aged between 35 and 69) are more likely to run current account surpluses.
• We show how demographic shifts have influenced global current account trends in the past 30 years, and what they imply for the next 20 years and beyond.
• We have seen some rebalancing from the extremes in 2008 but the process is not yet complete.
• Demographic shifts point to a cleaner split between emerging markets (mostly in surplus) and developed markets (mostly in deficit) in the future than is evident in the current, more complicated picture.
• Emerging markets (EM) could continue to lend to developed markets (DM) on average.
• Demographic forces may help keep global real rates low.
• The development of EM capital markets may be important in offsetting demographic pressures for capital flows from the EM to the DM world.

For the full article, click here.

Positioning happens before the fact

As a long term value-oriented investor, I often find that much of my research focuses on events and possibilities that do not come to fruition. I spend a lot of time hypothesizing about different scenarios and planning “just in case”. Lest you think that I can plan for every eventuality, let me assure you I can’t. What I can work through, however, are the triggers that need to be in place for an investment to look attractive. For technicians, these set-ups tend to be focused on charts, time and price indicators, or specific patterns. For me, it focuses on valuation, spread/ratio analysis, and long term trends.

To that end, I thought it might be worthwhile to share some of the relationships we’re focusing on, though not necessarily acting.

1. Gold/Silver: This ratio should could get out of line if gold becomes the safe haven leaving its cousin in the dark. The 12 month average is hovering at 64, and the ratio currently stands at roughly 68, but it could get much wider. If it does, we’ll be looking to determine if there is a structural shift or an overextended move.

2. EUR/USD

This is an example of a ratio that in our mind will continue to move for structural reasons and may not revert to any mean. Even with short-term intervention, the structural problems of a unified monetary policy without a unified fiscal policy are obvious and require sacrifices that disparate politicians cannot make.

3. S&P 500 vs. Russell 2000

Until recently, small caps handily beat large caps. In the search for performance, investors looked towards small caps, and even RSP and EQL got a boost vs. the market cap weighted SPY. We anticipate that ratio to go back towards it’s average. Lots of ways to implement it, but for it continues to be a telling sign of risk reduction in the equity space.

So these are on radar screen right now. Where will we look for opportunities in the future? For starters, we are in a deflationary period, so absolute levels in financial assets globally will be under pressure. That’s OK by me, since I’ll be looking to pick up cheap assets.

1. Thailand: Not ready to take the plunge on an absolute basis, but this is one market I anticipate will have some good long term opportunities. Valuations, demographics (internal and increased tourism), and wealth transfer from west to east all play into it.
2. Europe: Eventually, Europe will look attractive. I purchased NBG and OTE (Greece) after posting about it last week. We’ll be looking for over-reactions in other European countries as the fear increases (euro exposure will be hedged out).
3. Japan: Same as Europe.
4. US markets: we get questions about the US markets all the time. We view them as 30-50% overvalued, but once valuations come in line, the US may end up being well positioned as the continued dominant player.

Let me be clear, I do not believe these are good values here. However, I believe you have to start thinking about positioning before it becomes obvious. Attractive valuations are a necessary but not sufficient pre-condition. An understanding of the macro environment must play a role in analyzing a long term investment.

Demographics making their way to the main stream

Is it confirmatory bias if I happen to read an article in the popular press that happens to support a point we made here a few days (and months) ago about demographics being a good indicator for long cycles, but bad on timing? Just some sampling from the article:

Simple Demographics Shows Why US Housing Is Screwed, Japan Is Doomed, And Vietnam Is The Place To Be

(This guest post comes courtesy of The Mad Hedge Fund Trader)

Desperate homeowners counting on a “V” shaped recovery in residential real estate prices to bail them out better first take a close look at global demographic data, which tells us there will be no recovery at all. . .

…It turns out that population pyramids are something you can trade, buying the good ones and shorting the bad ones. These graphical tools told me in 1980 that I had to sell any real estate I owned in the US by 2005, or face disaster. No doubt hedge fund master John Paulson was looking at the same data when he took out a massive short in subprime securities, earning himself a handy $4 billion bonus in 2007. To see what I am talking about, look at the population pyramid for Vietnam.

This shows a high birth rate producing ever rising numbers of consumers to buy more products, generating a rising tide of corporate earnings, leading to outsized economic growth without the social service burden of an aged population. This is where you want to own the stocks and currencies.

Now look at the world’s worst population pyramid, that for Japan. These graphs show that a nearly perfect pyramid drove a miracle stock market during the fifties and sixties which I remember well, when Japan had your textbook high growth emerging market economy.

That changed dramatically when the population started to age rapidly during the nineties. The 2007 graph is shouting at you not to go near the Land of the Rising Sun, and the 2050 projection tells you why. By then, a small young population of consumers with a very low birth rate will be supporting the backbreaking burden of a huge population of old age pensioners.

Every two wage earners will be supporting one retiree. Think low GDP growth, huge government borrowing, deflation, and a terrible stock and housing markets. If you are wondering why I am aggressively shorting the yen right now, this is a big reason. Dodge the bullet.

If demographics is destiny, then Americas outlook sucks. Brace yourself. We are turning into Japan. As a silver tsunami of 80 million baby boomers retires, they will be followed by only 65 million from generation “X”. The intractable problems that unhappy Japan is facing will soon arrive at our shores. Boomers, therefore, better not count on the next generation to buy them out of their homes at nice premiums, especially if they are still living in the basement, and not paying any rent.

…Vietnam was one of the top performing stock markets in 2009. It was a real basket case in 2008, when zero growth and a 25% inflation rate took it down 78% from 1,160 to 250. This is definitely your E-ticket ride. Vietnam is a classic emerging market play with a turbocharger. It offers lower labor costs than China, a growing middle class, and has been the target of large scale foreign direct investment. General Electric (GE) recently built a wind turbine factory there. You always want to follow the big, smart money. Its new membership in the World Trade Organization is definitely going to be a help.

Read more: http://www.businessinsider.com/simple-demographics-shows-why-us-housing-is-screwed-japan-is-doomed-and-vietnam-is-the-place-to-be-2010-4#ixzz0kwuvY6H0

This is in no way a recommendation to buy Veitnam or is this a suggestion that this is an indicator that can be used in a timely manner. However, it may make sense to look at the long term demographics for long term investing.

Inflation Adjusted DJIA vs. Demographic of 45-54 Year Olds

We often discuss the BIG THEMES, such as wealth transfer from baby boomers to younger generations, wealth transfer from west to east, etc. Then, on the other side, we delve into valuations, expected returns, and what factors the markets have already priced in. One indicator that we have discussed in the past deserves an update.

Harry Dent discussed looking at spending patterns of different age groups, then mapping those to the equity markets, which would make sense since company earnings, being driven by consumer spending, should be impacted. Then, a couple of years ago Daniel Arnold came out with a book that had a sensationalist title (The Great Bust Ahead), and built on Dent’s ideas. So I decided to revisit some of their work.

To start, let’s look at spending patterns by different age groups:

(Source: HS Dent Foundation)

Then, Dent goes on to map the highest spending group (46-50 year olds vs. the inflation adjusted Dow):

(Source: HS Dent Foundation)

As you can see, we were off-course in 2009, as the Dow “should have been” at 11K – guess where we are now?

So where do we go from here? Well, Arnold shows us some of the same information, with some estimates going forward:

(source: http://www.thegreatbustahead.com/)

There are a few differences between the series used (such as Arnold using 45-54, not just 46-50) but the idea is the same: we recover into 2010-2012 and then go down on an inflation adjusted basis something on the order of 50%.

If you visit the site above, you’ll also see the statistics for Japan, which imply a sharp rebound (although I think US based investors will lose on the currency, but for those able to hedge out the currency, the Japanese markets have some potential).

There are two ways to achieve the performance above: the markets could go down or inflation could rise significantly (or a combo). We often discuss longer term indicators that are not great for market timers, such as q-ratios, CAPE, and now this one. Yet, they all point to similar fingers of instability that we’ve discussed in the past, and pose serious dangers for the longer term investor.

The really big trends are written in the cards

I am flooded with blogs and research reports and information, yet, every once in a while, I read something that makes me stop and consider the truly long term implications. Recently, I have been focusing my attention on the healthcare debate and the long-term implications of the forces at play. Yesterday, however, I read something about the demographic implications for the stock market and it’s not encouraging. I’ll provide a few choice quotes, but I highly encourage readers to read the entire article from www.tradersnarrative.com:

Recently, Ajay Kapur of Mirae Asset (from South Korea) has dusted off this well known ratio and given it a new, sexier name: “Demi-Ashton” ratio, in reference to Demi Moore and her much younger husband, Ashton Kutcher. And more importantly, he has put the ratio through its paces for all major stock markets around the world, coming up with the best and worst markets going forward.

Since the US stock market is our main interest here (and elsewhere), lets take a look at it first (chart to the left). According to the Mirae research report, the MY Ratio for the US will continue to trend lower and level off in the next few years. This is not good news for the bulls. While the MY Ratio will not fall anywhere near the levels it reached in the 1980’s, it will not rise. My own conclusion is that this means we will probably see a range bound but possibly quite volatile market.

The best markets to invest in now, in order to take advantage of an improved MY Ratio in the near future are quite surprising. Among the developed countries, Japan tops the list. Shocking, right? After all, their stock market has been moribund for decades. But according to demographics, the Japanese will experience another boom as the MY Ratio climbs in the next decade. And for developing markets, Russia and Eastern Europe top the list.

Surprisingly, China’s MY Ratio (not shown) also tells us that the best times in the Chinese stock market may already be behind them.

For the full article, go here: http://www.tradersnarrative.com/does-demographics-drive-the-stock-market-2910.html.

Also, to view the research mentioned in the article, click here.