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It isn’t difficult to argue that demographics is one of the most powerful engines of destiny for society and in turn every important facet within it, including the economy and the stock market. Think about it. Demographics determines what the priorities of a society, their spending patterns, their saving patterns, and beyond.
We are all familiar with the power that the ‘baby boomers’ have held sway over the North American economy for these past 50 years. Everything from modern marketing to pharmaceutical research (Viagra) has been shaped by their needs and wants.
So not surprisingly, this topic has garnered a lot of attention from academics in the field of economy. There are many studies which look into the consequences of demographics and you can find one at the end of this article.
In fact, this area of study has come to be a well worn path for economist. So much so that there is a short hand to describe a most intriguing ratio: MY ratio which stands for the middle-aged to young ratio or simply Middle-Young.
This ratio is key because in these two different stages of life, people have very different priorities which, aggregated as a great galloping herd, has an inevitable effect on the pattern of savings, spending and investing that happens in a given society.
When you are young, typically, your income is very small to non-existent. You are interested in spending primarily. Both as a means of entertainment and as a way to gain education in order to achieve your full earning potential later in life. So at this stage, the average young person has much higher expenses than income - which results in debt.
On the other hand, in middle age, the average person has reached their peak income potential. They do have expenses obviously but they are also mindful of their impending retirement and as a result, saving a portion of their annual income and investing it. The majority of this investment flows to the equity markets because that is where the best risk adjusted returns are.
The idea is to watch for the relative size of the asset rich, middle-aged members of a society to their much younger and poorer counterparts. If we have a low ratio, this means that there are fewer middle-aged people and relatively more younger people. And when the ratio is higher, there is an abundance of the older generation and less youth.
So it would follow then that demographics and especially the MY ratio potentially not only describes the fluctuations in the stock market, it also may explain the expansion and contraction in the Price/Earnings ratio.
After all, when you have an abundance of middle-aged investors chasing after stocks, they will be ready to pay a higher and higher price for them. And inversely, when you have few middle-aged investors there will be few competitive bidders for equities, allowing stocks to become extremely ‘cheap’.
Here is a chart from The Cowles Foundation for Research in Economics (authored by John Geanakoplos, Michael Magill and Martine Quinzii) which shows a remarkable correlation between the P/E ratio and the MY Ratio:
Recently, Ajay Kapur of Mirae Asset (from South Korea) has dusted off this well known ratio and given it a new, sexier name: “Demi-Ashton” ratio, in reference to Demi Moore and her much younger husband, Ashton Kutcher. And more importantly, he has put the ratio through its paces for all major stock markets around the world, coming up with the best and worst markets going forward.
Since the US stock market is our main interest here (and elsewhere), lets take a look at it first (chart to the left). According to the Mirae research report, the MY Ratio for the US will continue to trend lower and level off in the next few years. This is not good news for the bulls. While the MY Ratio will not fall anywhere near the levels it reached in the 1980’s, it will not rise. My own conclusion is that this means we will probably see a range bound but possibly quite volatile market.
The best markets to invest in now, in order to take advantage of an improved MY Ratio in the near future are quite surprising. Among the developed countries, Japan tops the list. Shocking, right? After all, their stock market has been moribund for decades. But according to demographics, the Japanese will experience another boom as the MY Ratio climbs in the next decade. And for developing markets, Russia and Eastern Europe top the list.
Surprisingly, China’s MY Ratio (not shown) also tells us that the best times in the Chinese stock market may already be behind them. Here is a recent interview with Ajay Kapur with Bloomberg TV:
And here is a short excerpt from the study which I mentioned above:
The results that we obtain strongly support the view that changes in demographic structure induce significant changes in security prices – and in a way that is robust to variations in the underlying parameters. When we parametrize the model to US data, we obtain variations in the price-earnings ratios which approximate those observed in the US over the last 50 years, and in line with recent work of Campbell and Shiller (2001), the model supports the view that a substantial fall in the price-earnings ratio is likely in the next 20 years.
Keep in mind that that was written in 2002. And so far, we’ve had a bull market and a bear market since then. So it is important to stress that what we are talking about are massive, generational waves which set the general context for much smaller fluctuations. It is entirely possible to have powerful bull market rallies inside a very bearish extremely long term bearish trend. But if demographics does indeed power the stock market, then North American markets are in for a very disappointing ride ahead.
Here you can download the complete study: Demographics and the Long-run Predictability of the Stock Market (PDF). If for some reason this link doesn’t work, look for the research paper in the Free Trading Resource section of the site (Reports & Articles folder).
And I would also highly recommend Bull’s Eye Investing by John Mauldin which mentions this and many, many other interesting ways to value and time the stock market. It is chock full of great insight and information. At a hefty +400 pages, I’ve found it to be a great reference book which provides an almost limitless fount of guidance to dip into again and again.
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