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Does Demographics Drive The Stock Market? at Trader’s Narrative

Does Demographics Drive The Stock Market?

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:

MY ratio compared to PE ratio 1910 to 2000

MY ratio demographics for USRecently, 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.

MY ratio demographics for Japan MY ratio demographics best worst 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.

bulls eye investing mauldin book coverKeep 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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8 Responses to “Does Demographics Drive The Stock Market?”  

  1. 1 Declan Fallon

    Great Stuff Babak!

    I suppose the idea of the secular market is born from demographics? I agree on the idea of Japan been the next secular bull market as it approaches the end of its secular bear market. The US is in the middle of a secular bear market depending on whether you judge the S&P (1998) or Nasdaq top (2000) as the start.

    The start of the secular bull market in Japan will help kick start the next cyclical bull market in the US, before all that money supply comes back to haunt the US and drop it into its final phase cyclical bear (in a secular bear market).

    Sushi here we come…

  2. 2 blues

    You want to know what’s driving the stock? Here…

    Extra money from Uncle Ben…

  3. 3 larry

    Nice post. You might also look at Harry Dent’s work (which pre-dates Kapurs’ work by several years). Dent made some pretty outrageous claims about the level the markets would reach, but his demographic work appears to have correctly predicted several trends. Also enjoyed Blues’ comment. Would like to see longer term picture. Thanks for the good work.

  4. 4 Joe Eifrid

    Call it ‘Demogranomics’ - It’s over..

    It’s over. Economic prosperity as we knew it is dead. This debt thing will affect the economy for several years - but there is more. I just read an article where a small bank has no money to lend at all because the interest they would have to pay investors is too high and there isn’t even a market anymore for selling that debt. They can’t sell equity because it dilutes current shareholders too much.

    By the time we work through these debt issues we will be deep into baby-boomer retirement. The boomers are the ones that gave us the growth over the last 20 years. When you have a generation of 49 million being replaced by 80 million you are going to have growth. The next generation after the boomers is almost equal in size. No growth will be coming from this group when they reach their most productive years.

    Then you have to think about the cultural changes that came about during the boomers years. How much extra automobile production was necessary to go from a driveway with one car in the 50’s to 2 or more by the 90’s? Think of all the extra building materials used over the last 40 years to build two and three car garages instead of one, or in many caes just carports.

    And women went to work. Just think of all the extra clothing that was bought as more and more women entered the work force. How do you replace that growth? How about closest space?. Look how many industries may have seen higher growth from houses getting larger. Easily two to three times more toilets were sold per house than what we saw prior to the fifties. The average size home in 1970 was 1500 square feet. In 2005 it was 2,434 square feet.

    And this all came about with cheap energy. Cheap energy is gone forever. The means less disposable income to buy those extra items that we all bought in the last 40 years.

    Then we had the break up of the family as divorces became more common. The average size household in 1950 was 3.38. It was 3.68 in 1940. Today it is about 2.57 people per household. If we still had 3.38 folks per household there would be a need for 15 to 17 million less households than what we have today. Think about how much that contributed to growth in the boomer years. As the economy slows households may start to get larger again as many will no longer be able to afford to live on their own. I can vision large subdivisions becoming ghost towns.

    You won’t read anywhere about what I mentioned above. Nobody that has the floor has thought much about where past growth came from. They are too quick to just assign it to the size of the baby-boom generation. It is way more than that. A generation that through it’s size and mostly cultural changes gave us an economy on steroids - an economy that many take for granted as just being more of the norm that we became accustomed too.

    …and there is more I could get into to prove my point about the death of economic prosperity for at least the next 15 years.

    I was going to write a book about this stuff but probably will never get around to it. The consequences to the next generation and those after are going to be monumental. I was going to title the book ‘Demogranomics’. It’s a word I coined. Go ahead, google it. It’s the study of the demographics and the economy of the boomers.

    Joe Eifrid

  5. 5 Joe Eifrid

    Harry Dent’s book from 1992, ‘The Great Boom Ahead’ really caught my attention I got me thinking and researching more about demographics. He was spot on several of his predictions although I think he swayed from some of his earlier thinkings in around 2005 when he predicted enormous gains in the dOW and Nasdaq.

    One of his predictions from his book in 2002;

    “The next depression from 2010 to 2025″

    “Little or no inflation over the coming 20 years, dispite dramatic economic growth.

  6. 6 Sajal

    I agree on the Bull’s Eye Investing recommendation. I’ve recommended the book several times as well on my blog.

  7. 7 Babak

    blues, David Rosenberg says in a recent commentary: “You can always rest assured that a peak is at hand when you read and hear about how ‘liquidity’ is driving the market. For one, nobody even has a clue as to how “liquidity” is even defined. It’s basically a catch-all term for ‘I don’t know’.”

    But seriously, a 6 month long correlation? what does that prove? If we wanted to, I bet we could find a half year correlation between the S&P 500 and the price of butter in Botswana.

  8. 8 Kary Luzi

    Thanks I really needed this.

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