Why Investors Should Consider Demographics

by: Cam Hui, CFA

I wrote back on July 8, 2010 about an academic paper by Geanakoplos et al entitled Demography and the long-term predictability of the stock market, where the authors related stock market returns and long-term P/Es. Reading between the lines, they forecast a 1982-style (my words, not theirs) market bottom about 2018.

Now, I see that others have jumped on the story. Mark Hulbert has highlighted some analysis from Ned Davis Research indicating that American age demographics will be more youthful than China's by 2020. Hulbert pointed to a paper that concluded that investors don't pay much attention to demographics, even though age demographics is highly predictable and such trends exploitable by investors.

Here is the abstract [emphasis added]:

Do investors pay enough attention to long-term fundamentals? We consider the case of demographic information. Cohort size fluctuations produce forecastable demand changes for age-sensitive sectors, such as toys, bicycles, beer, life insurance, and nursing homes. These demand changes are predictable once a specific cohort is born. We use lagged consumption and demographic data to forecast future consumption demand growth induced by changes in age structure. We find that demand forecasts predict profitability by industry. Moreover, forecasted demand changes 5 to 10 years in the future predict annual industry stock returns. One additional percentage point of annualized demand growth due to demographics predicts a 5 to 10 percentage point increase in annual abnormal industry stock returns. However, forecasted demand changes over shorter horizons do not predict stock returns. The predictability results are more substantial for industries with higher barriers to entry and with more pronounced age patterns in consumption. A trading strategy exploiting demographic information earns an annualized risk-adjusted return of 5 to 7 percent. We present a model of underreaction to information about the distant future that is consistent with the findings.

My conclusion has been equity markets are likely to go sideways until the end of this decade. I wrote that:

Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.

During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Inflation-Deflation Timer Model to capture the swings of a flat market.