Thursday, September 1, 2011

Demographic trends and stock market prices

Research from FEDERAL RESERVE BANK

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.


















Source: Federal Reserve Bank

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. The above graph compares the actual and model-implied P/E ratios for the sample period ending in 2010. We calculate the path for the model-implied P/E during the sample period by feeding in actual M/O ratios. We call the long-run path of the P/E ratio predicted by the model the “potential P/E ratio” and designate it P/E*. Figure 2 shows that the P/E* (red dashed line) is highly correlated with actual P/E during the sample period.

What does the model say about the future trajectory of the P/E ratio? To generate a forecast for actual P/E from 2011 to 2030, we must first project P/E* for that period. To obtain this future P/E* path, we calculate the projected M/O ratio from 2011 to 2030 by feeding Census Bureau projected population data into the estimated model. The graph shows that P/E* should decline persistently from about 15 in 2010 to about 8.4 in 2025, before recovering to 9.14 in 2030.

We are also interested in forecasting the potential path for stock prices. Since we have forecast a path for the P/E ratio, predicting stock prices is straightforward if we can project earnings, the E part of the ratio. For this purpose, we assume that, in the next decade, real earnings will grow steadily at the same average 3.42% annual rate by which they grew from 1954 to 2010. To obtain real earnings, we deflate nominal earnings by the consumer price index.

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.

Read the full research here.

Geir Solem
http://www.elliottwavetechnician.blogspot.com/
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