What Will the Baby Boomer Bust Mean for Equities?

In coming decades, many forces will shape our economy and our society, but in all likelihood no single factor will have as pervasive an effect as the aging of our population. (Ben Bernanke, Fed Chairman)

It is crucial for investors to disentangle cyclical from secular economic trends, and discover opportunity where they converge. For example, six months ago the oil market was gripped by hysterical fear regarding the deteriorating secular supply growth trend (although Peak Oil is a political and economic rather than geological phenomenon in my view i.e. the still plentiful oil is in the wrong places with soaring marginal costs of production). I warned consistently that traders were underestimating cyclical demand destruction, already evident in the US and spreading to emerging markets. That disparity presented a low-risk and hugely profitable shorting opportunity. Now the opposite applies, with prices below marginal production costs, many key new development projects being shelved, nearly all OPEC producers facing fiscal deficits in 2009, and the oil market in steep contango.

Demographic decline is the most powerful secular trend we now face (in the sense that the 15-64 population cohort will shrink across the developed world, and in Russia and China), which will have a huge impact across all markets. I've previously discussed this issue in relation to Japan, the first developed nation to hit the demographic tipping point. For some superb charts illustrating the severity of the labour force adjustment we face, I recommend downloading a recent overview from KPMG here (charts on pages 7-12). The long-term investment implications of this historic shift in population structure will be profound; broadly, I would expect to see lower trend labour productivity and output growth, rising structural deficits (as retiree entitlement spending and the dependency ratio soar), and a growing shortage of global savings rather than the excess that fueled the credit boom.

As the 79 million Americans born between 1946 and 1964 begin retiring, one key investment impact may be on the the Equity Risk Premium ((ERP)), the excess return an investor earns by investing in the risky and volatile stock market above the risk-free return available on government bonds. Recently, it has soared as equities have slumped; the ERP on US equities was just over 4% in early September (from a range low of sub 3% in 2000) but hit over 6% in the depths of the October crash (precise estimates of the ERP vary according to methodology, but the recent spike is indisputable).

Beyond current extreme risk aversion, factors affecting its sustained level over time include changing demographics, monetary and tax policy and dividend yields. There was a historic structural break in the ERP relationship in the mid 1950's when the reverse yield gap opened up i.e. equities began yielding less than bonds as investors discounted rising dividend growth prospects in the post-war economic (and baby) boom. Significantly, that reverse yield gap has now turned positive in Japan, the UK and Germany, and is at the lowest levels in 60 years across all major markets including the US. Does this just reflect a short-term deflation panic? The ongoing bursting of the bubble in normalized equity valuations since 2000 (when a secular bear market commenced) has been one factor, but our passing the inflection point of the baby boomer investment cycle may become the key underlying influence.

The Baby Boom generation hit their peak earning and savings years between ages 40-60, and from 1984 onward they began having a profoundly bullish impact on US financial markets and economic growth. Their soaring inflows into equity mutual funds significantly increased the size of the equity market relative to the US economy and their productivity and consumption boosted trend corporate earnings growth. From 1980 to 1999, the US equity market generated a real annual return of about 13 percent, over twice its long term historic average. By then, cyclically adjusted PE ratios were at levels not seen since 1929. As retirement approaches, baby boomer funds will steadily move from risky long duration assets to safer short duration (a process well underway but set to accelerate post 2010), and then get drawn down post retirement rather than accumulated, and the logical impact on the equity market is secular upward pressure on the ERP.

Although stocks now look reasonably valued long-term on a cyclically adjusted peak earnings basis, and should theoretically offer total returns in the high single digits from here, that assumes we have seen a cyclical, not structural shift in the ERP, and fair value gradually reverts to a recent historical norm of about 4%. To offer some historical perspective from a time before the equity cult took hold, from 1936 to 1958 S&P equity yields fluctuated between 4% and 7% and bond yields between 2.5% and 3.5%. Equities yielded more than bonds consistently through that period.

Is this the mean we're reverting to? Quite possibly; I certainly believe that academic models should use corporate rather than government bond yields in the current environment, in which case the kneejerk valuation case for equities is less than compelling. The grim earnings and cashflow outlook for 2009 also implies that aggregate equity yields are overstating the valuation merits of stocks on current dividend streams. None of this changes the oversold condition of markets near term, and likelihood of a sustained bear rally in coming months, but it is crucial to maintain an objective long-term perspective.

On a brighter note, the 2008 Nobel Prize winner for economics, Paul Krugman, is gatecrashing Nouriel Roubini's Armageddon party and talking Depression in his NYT column. This is the same guy who stated unequivocally in January 2006 that soaring US house prices were not a bubble. In June 2008, he claimed with equal confidence that a $140 oil price was justified by fundamentals. Call me a cynic, but doesn't that make you feel just a little bit more bullish?

Comments

[Steven Hansen:]

i doubt whether the boomers will plunge into the market - they might just get their feet wet if they go in at all. this crash was a wake up call. until now, i invested very aggressively. this just won't happen any more because it is not worth betting the farm for a few more bucks in the bank when what i have now is enough for retirement.

sean, this was a good analysis.

2008 Nov 18 04:47 AM

[jp23:]

boomers were the primary group that made the stock market go up...as they leave the market, they will make it go down since the younger generation will not be investing as much as the boomers.

2008 Nov 18 04:55 AM

[peterthepai...:]

good article...the 1980 - 2000 type bull market is not going to happen again for a long, long time...too long for many of us...this bear has legs...

2008 Nov 18 05:12 AM

[ERP software:]

Hi,
Good article. boom always bursts

2008 Nov 18 07:25 AM

[pockyclips ...:]

Mr Leaf blower and Ms Walmart checker aren't going to be buying stocks when the peak of the boomers hit retirement. If were lucky, we may get a Dow up to 12500 in the next 4 years.

2008 Nov 18 09:16 AM

[Smarty_Pants:]

Boomer retirement will dampen any hope of upward market moves. For the next 20 years the Boomers will be cashing in their retirement plan assets, effectively putting a lid on rallies.

Publically traded companies would be wise to shift gears and operate on a sustained dividend generation model for the foreseeable future. Yield will be better received than price appreciation. Retiring boomers need cash flow.

2008 Nov 18 10:06 AM

[m1kee:]

You are right to state that Krugman in January 2006 stated that soaring US house prices were not a bubble. As I recall he stated this even earlier in 2004 or 2005, so I am not quite sure what you are referring to.

2008 Nov 18 12:35 PM

[Larry House:]

I would refer interested readers to the books of Harry Dent. He has done much analysis on the changing tides as Boomers retire. He is also calling for a major Depression to begin in late '09 or early '10. Time will tell.

2008 Nov 18 01:57 PM

[zorkfin:]

With Bush out of the office it will be more difficult to get the Nobel prize. Gore and Krugman just fitted the bill, Moore and Franken will have to figure something else.

2008 Nov 18 05:48 PM

[doubleguns:]

Retirement went out the window with this market. Boomers will now have to pull 2X more out of the market to keep up and a lot less people putting into the market.

Time to buy an island in the south pacific, learn to fish real good and grow vegitables. Thats about the only feasable retirement program now. Whos in!!!! The more the merrier and a bigger island we can buy.

Social security is the next government fiasco that is going to clobber us. They just spent all the money and probably will cut benifits or print so much more money. Boomers will then pull more out of the market and round and round we go just above the drain circling.....circling....

2008 Nov 18 06:01 PM

[Did U Think...:]

If Dow is 12k again in 4 years it will be due to hyperinflation. The Dow is going down 90% from its peak just like it did 1920-33. We had a greater bubble and there will be a greater depression. I am not talking short term this and that. I'm talking about a market bottom within 18 months of today followed by a 3-5 year depression for the economy. The Dow will take 2 decades to reach its old highs without adjusting for inflation just like it took until 1955 to occur after the crash of 29-33. History is repeating itself BEST case. Worst case, Dumb Ass Bernanke inflates the currency into Weimar 2.0 and leads us into WW3.


On Nov 18 09:16 AM pockyclips 2020 wrote:

> Mr Leaf blower and Ms Walmart checker aren't going to be buying stocks
> when the peak of the boomers hit retirement. If were lucky, we may
> get a Dow up to 12500 in the next 4 years.

2008 Nov 18 07:10 PM

[Did U Think...:]

Doubleguns,
Have you been looking at islands? I have! You need something high and dry. You want about 10 acres with 5 families living there (preferrably early 50s) so that people can help each other buy the place and build on it. You are looking at needing about 400k per family to get started but then it could be a load of fun.


On Nov 18 06:01 PM doubleguns wrote:

> Retirement went out the window with this market. Boomers will now
> have to pull 2X more out of the market to keep up and a lot less
> people putting into the market.
>
> Time to buy an island in the south pacific, learn to fish real good
> and grow vegitables. Thats about the only feasable retirement program
> now. Whos in!!!! The more the merrier and a bigger island we can
> buy.
>
> Social security is the next government fiasco that is going to clobber
> us. They just spent all the money and probably will cut benifits
> or print so much more money. Boomers will then pull more out of the
> market and round and round we go just above the drain circling.....circling....

2008 Nov 18 08:58 PM

[pockyclips ...:]

Exactly my point. Printing money will produce a temporary bubble before the final meltdown. The guy buying a south sea island may have the best plan.
Or turn 65, rob a bank, and let the state care of you. Health care, housing and food. Who needs freedom?


On Nov 18 07:10 PM Did U Think The Ponzi Scheme Would Last? wrote:

> If Dow is 12k again in 4 years it will be due to hyperinflation.
> The Dow is going down 90% from its peak just like it did 1920-33.
> We had a greater bubble and there will be a greater depression.
> I am not talking short term this and that. I'm talking about a market
> bottom within 18 months of today followed by a 3-5 year depression
> for the economy. The Dow will take 2 decades to reach its old highs
> without adjusting for inflation just like it took until 1955 to occur
> after the crash of 29-33. History is repeating itself BEST case.
> Worst case, Dumb Ass Bernanke inflates the currency into Weimar 2.0
> and leads us into WW3.
>
>
> On Nov 18 09:16 AM pockyclips 2020 wrote:

2008 Nov 20 08:24 AM