Demographic Forces Will Remain A Market Headwind

by: Michael Blair

The 2008-2009 real estate bust has been blamed quite correctly on sub-prime lending and related excesses. But there is some question about whether it might have occurred in any event, perhaps to a lesser degree, simply based on demographics.

In the years since the crisis we have seen many articles and comments suggesting that the unemployment rate data are suspect since the apparent lowering of the unemployment rate since 2009 was in part due to a reduction in the so-called "participation rate" which some pointed to as evidence that unemployment is understated because of a high number of "discouraged workers" who have left the labor force simply frustrated at their inability to find a job.

I have never like subjective statistics like the "participation rate" because of the difficulty of measuring the measures of "discouraged workers" or alternatively "those actively seeking work" since they depend by and large on survey data, typically less reliable than measured data in my opinion.

Some data I came across recently point to an explanation for both the collapse in real estate prices and the questionable unemployment statistics.

Source: Business Intelligence

The above chart from Business Intelligence points to a high correlation between house prices and the inverse of a statistic called the dependency ratio. The dependency ratio is the proportion of working age population to the combined number of too old and too young to be in the workplace. The inverse chart shows that as the proportion of dependent population grows in relation to working age, home prices fall, not just in the United States but worldwide.

The correlation is objective, not subjective, and makes sense. As the proportion of working age families falls the demand for new housing falls and the existing housing stock tends to oversupply as elderly move from homes into retirement residences and elderly care facilities.

At the same time, the number of people able to "actively seek work" drops as the working age population takes on a greater number of dependents who need care, whether old or young.

This trend is with us for a while as baby boomers leave the work force and as the elderly live longer. The implication is slower economic growth worldwide and in part explains why massive stimulus by all governments has been relatively ineffective in returning economic growth to levels that were heretofore considered "normal". Quantitative Easing ("QE") is not a uniquely American initiative but has its parallels in growth of the balance sheets of the Central Banks in Europe and China.

Source: Business Intelligence

The effect of continued stimulus in the form of so-called QE will not be accelerated growth. QE cannot "stimulate" more job creation when the demographic evidence is that the supply of workers is in fact the real issue regardless of the reported unemployment rate. Rather, the effect of the QE programs worldwide will eventually be inflation in an environment where growth is very likely close to its sustainable level already creating a round of what used to be called "stagflation" - that is, higher nominal rates of growth but low real growth.

Stagflation, if it occurs, will exacerbate the gap between rich and poor worldwide. Higher nominal prices increase costs for those least able to absorb higher costs while creating what we used to call "inventory profits" for those holding hard assets and controlling the means of production. In poorer regions of the world the continued QE is more likely to lead to civil disorder than to accelerated growth as the pressure on the working poor intensifies.

High inflation and civil disorder is already evident in Latin America, Turkey, the Ukraine, and parts of Africa. The pressures are contagious in my view and will expand to India and China and ultimately to Europe eventually finding their way to North America.

For example, the inflation rate in Venezuela is over 50%.

In India, inflation is flirting with double digits.

Policy makers have been concerned with deflationary pressures since the financial crisis and for good reason. They want to avoid the deflationary dilemma Japan has struggled with for at least 20 years.

Higher inflation is a necessary evil to bring outsized sovereign debt to a manageable proportion of GDP but the tendency of inflation to benefit the rich and further impoverish the less fortunate must be offset with balanced policies that protect the lower and middle classes to a certain extent or there will be blood on the streets in many parts of the world.

The high likelihood is that the market advance of recent years has run its course and any further advances in the major indices are likely to simply give rise to sharper falls as the markets correct themselves to reflect the economic - and in my view this means demographic - realities.

Investors need to take heed. When the outlook could not be better it is time to raise cash and reduce exposure for precisely that reason. It could not be better, but it could be a lot worse.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.