Investors often become overly concerned about a given day's move in financial markets, the most recent economic data point, or the quarterly earnings of a company relative to analyst projections. This investment nearsightedness can cause investors to miss large investment themes that evolve over long time periods, and substantially affect the value of their portfolio. Seeking Alpha's forum on Demographics provides an excellent medium for discussion of these longer-term themes.
In February, I authored an article that drew on Federal Reserve Bank of San Francisco research that demonstrated that the ratio of middle-aged (M) Americans (aged 40-49, peak earnings) relative to older (O) Americans (aged 60-69, transitioning to retirement) explained the majority of the variability of the price-to-earnings ratio of the S&P 500 (SPY). Said alternatively, the single largest driver for how much investors collectively paid for a dollar of earnings was the ratio of peak earners in their 40s to new retirees in their 60s in the population.
In academic literature, the outsized Baby Boomer generation (born 1946-1964) is often cited as a demographic headwind for the economies of the United States, western Europe, and especially Japan. As this large generation reaches retirement age in the United States, reductions in tax revenues from their absence from the labor force and the necessary increase in entitlement spending (Social Security, Medicare/Medicaid) has been presaged to exacerbate structural domestic budget deficits, potentially crowding out other portions of the economy. Retiring investors should also be reducing equity investments and shifting their investment funds towards less volatile fixed income securities as they spend down savings from peak earning years. This decrease in demand for stocks is a key explanation for the future depressed earnings multiples in the graph below also from the Federal Reserve Bank of San Francisco.
At least one analyst has a different take altogether. Tobias Levkovich, chief U.S. equity strategist for Citigroup (C), had a bullish take on the demographic backdrop in the United States in his recent chart book "Exploiting the Gap Between Fundamental Reality and Market Perception: The Delve into Twelve (and Beyond)." Below is a graph of the population of the 35-39 age cohort on the left axis and a logarithmic scale of the S&P 500 (and its predecessor indices) on the right index. The children of the Baby Boomer generation are beginning to ramp up their retirement savings years as they enter the beginning of their peak earning years in their mid-30s. If Levkovich's correlation between this age cohort and market performance persists, then an equity market rebound should be expected over the next several decades. This relationship could also partly explain the poor equity returns of the past decade, as the last of the Baby Boomer generation moved past this 35-39 age cohort, shrinking its size.
Perhaps low fixed income yields in the United States, relatively attractive earnings yields on stocks, and the effects of a poor decade of stock returns on the size of retirement funds will slow the transition of Baby Boomer portfolios from stocks to bonds. With the P/E ratio of the S&P 500 at only three-quarters of its long-term average, there is less room for the multiple to compress due to demographic trends. While I view the consensus estimate of economic headwinds from the shrinking Baby Boomer labor force and lowered equity multiples as the most plausible outcome, it is always important to consider counterevidence that goes against conventional wisdom.