There has been some buzz in the blogosphere about a paper published by researchers from the San Francisco Fed entitled Boomer Retirement: Headwinds for U.S. Equity Markets? In the paper, the authors concluded that, based on their demographic studies, "real stock prices are not expected to return to their 2010 level until 2027".
I had written about the effect of demographics on equity market returns before (see Wait 8 years for a new bull). I had referenced a 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.
What's the difference between the San Francisco Fed paper and the Geanakoplos paper?
The San Francisco Fed paper addresses that issue of methodology:
We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio.
By contrast, the Geanakoplos paper uses the M/Y ratio, or middle-aged to young ratio. The San Francisco Fed researchers justified their use of the M/O ratio this way:
We prefer our M/O ratio to the M/Y ratio of middle-age to young adults, age 20–29, studied by Geanakoplos et al. (2004). In our view, the saving and investment behavior of the old-age cohort is more relevant for asset prices than the behavior of young adults. Equity accumulation by young adults is low. To the extent they save, it is primarily for housing rather than for investment in the stock market. In contrast, individuals age 60–69 may shift their portfolios as their financial needs and attitudes toward risk change. Eligibility for Social Security pensions is also likely to play a first-order role in determining the life-cycle patterns of saving, especially for old-age individuals.
The results aren't all that different. Though many bloggers focused on the headline "real stock prices are not expected to return to their 2010 level until 2027", here is the full conclusion [emphasis added]:
The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. The subsequent recovery is quite slow. Indeed, real stock prices are not expected to return to their 2010 level until 2027. On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.
The San Francisco Fed researchers concluded that stock prices bottom in 2021, instead of 2018 as implied by the Geanakoplos paper. 2018? 2021? What's the difference? These kinds of estimate errors are to be expected in these kinds of long-term demographic studies. As they say, it's close enough for government work.
Range-bound markets until the end of the decade
These studies support my technical conclusion that we are likely to see volatile and range-bound stock markets until the end of the decade.
click to enlarge images
(Note that range-bound doesn't necessarily mean sideways or flat. Most recently, the SPX has been bounded by 666 on the downside and 1370 on the upside - which is quite a range.)
It's the valuation, stupid!
I recently came upon a better fundamental explanation of these mult-decade bull phases followed by multi-decade range-bound stock markets. The chart below from VectorGrader shows the market cap to GDP of US equities from 1950 (charts is theirs, the annotations are mine). Note how the bull phases coincided with expansion of the market cap to GDP ratio. The equity market then topped out and then became range-bound, which coincided with a corrective phase in the market cap to GDP ratio, until that "valuation" metric returned to more realistic levels.
Today, the market cap to GDP ratio has corrected some of its gains from the highs seen at the NASDAQ peak in 2000, but not entirely. If I were to eyeball the chart, a market bottom around the end of this decade is quite plausible and likely given the current rate of descent of that ratio.
An investment plan for a range-bound market
In July 2010, I wrote the following and I stand by my conclusions:
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 Asset Inflation-Deflation Timer model to capture the swings of a flat market.
Incidentally, the Timer Model is currently at a deflation reading, signaling a stance of maximum defensiveness. There is a new way of regularly accessing those model readings. I have been participating in the Ticker Sense blogger sentiment poll and the my "blogger opinion" is reflective of the model reading, where:
- Bullish = Inflation
- Neutral = Neutral
- Bearish = Deflation
The poll is updated on a weekly basis and the results are released on Mondays.