For some time now, different researchers have predicted that
once the Baby Boomers begin to retire, equity returns will suffer. The theory
is that retirees are less inclined to invest in stocks given their need for
income and their shorter investment time horizon.
However, a recent report from the Federal Reserve Bank of
San Francisco (FRBSF), “Global Aging: More Headwinds for U.S. Stocks?”, has
raised the specter that the impact of this demographic trend, though delayed,
remains a very real threat to future U.S. equity values. In fact, the FRBSF
report takes the position that current valuations, based on their formulaic
prediction, “suggest” that the P/E ratio of the S&P 500 will be cut in half
over the next decade.
This unfavorable prediction of the value of U.S. equities in
2025 is rooted in the work of Liu and Spiegel, which was first reported in an
earlier FRBSF Economic Letter in 2011, “Boomer Retirement: Headwinds
for U.S. Equity Markets?” According to the 2011 FRBSF Economic Letter, the
M/O ratio and the S&P 500 P/E ratio “appeared to be highly correlated”
between 1954 and 2010, which led the researchers to conclude that this evidence
suggests that U.S. equity values are closely related to the age distribution of
the population. Since demographic trends are largely predictable, we can
forecast the path that the P/E ratio is likely to follow in the next few
decades based on the predicted M/O ratio.
Of course, the prediction made by the 2011 FRBSF report did
not materialize between 2011 and 2015 given the fact that valuations have
expanded significantly during this period. The FRBSF’s recent report indicates
that the fact that this expansion has occurred in spite of the aging
population, “suggests that the P/E ratio will decline even more” than
originally projected in 2011. In other words, their view is that the theory
remains intact and the market will simply take a harder fall as a result of the
recent run-up in the U.S. equity market.
The recent FRBSF paper also looks beyond the U.S. market and
considers how the M/O and P/E historical correlation will potentially impact
the global equity markets. Their conclusion states although the U.S. figure
confirms a strong positive statistical relationship between the P/E and M/O
ratios, this relationship does not hold up well for the other G-7 countries.
The positive correlations for France and the United Kingdom are modest and statistically
insignificant, while Germany, Italy, and Japan yield negative
correlations…Therefore, the correlation between demography and equity values
that holds tightly for the United States cannot be extrapolated to the other
G-7 countries.
Analysis
There are a number of potential reasons why the high
positive correlation between M/O and P/E has not played out recently the way
the way Liu and Spiegel predicted in 2011:
- Many retirees are playing catch-up and, thus,
are taking on more risk in order to increase the size of their nest eggs.
- During the time period (1954 thru 2010) that Liu
and Spiegel studied the correlation of M/O and P/E, the pension system was
stronger and most retirees did not expect to have to rely on their savings to
carry them for 25 to 30 years in retirement.
- The end of the bull market for bonds and the
current low interest rates at all points on the yield curve has changed the
dynamics of investing as more retirees choose to depend more heavily on capital
appreciation and dividends as a means to achieve their income objectives.
- More retirees are choosing to continue to work
in retirement, either on a full-time or part-time basis, which enables them to
assume more investment risk.
Conclusion
The work of Liu and Spiegel and their finding that, at least
on a historical basis, there is a high positive correlation between an aging
workforce and the value of U.S. equities is something that every advisor and
money manager ought to consider. However, it is not clear that this correlation
should be extrapolated over the next 10 years.
For those retirees seeking higher returns in the stock
market, research reports such as this one should, at the very least, be viewed
as a yellow light.
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