This blog has mentioned couple of times – ignore demographics at your own peril (see my paper on this).

This new paper from FRBSF econs – Zheng Liu and Mark M. Spiegel – says demographics could lead to lower stock market indices in future. As baby boomers become baby busters, they would be moving away from equity as an asset class leading to its decline.

They develop a ratio – middle-age cohort, age 40–49, to the old-age cohort, age 60–69- and call it the M/O ratio. This M/O ratio depicts P/E ratio of S& P index really closely since 1954:

*Figure 1 displays the P/E and M/O ratios from 1954 to 2010. The two series appear to be highly correlated. For example, between 1981 and 2000, as baby boomers reached their peak working and saving ages, the M/O ratio increased from about 0.18 to about 0.74. During the same period, the P/E ratio tripled from about 8 to 24. In the 2000s, as the baby boom generation started aging and the baby bust generation started to reach prime working and saving ages, the M/O and P/E ratios both declined substantially. Statistical analysis confirms this correlation. In our model, we obtain a statistically and economically significant estimate of the relationship between the P/E and M/O ratios. We estimate that the M/O ratio explains about 61% of the movements in the P/E ratio during the sample period. In other words, the M/O ratio predicts long-run trends in the P/E ratio well.*

Infact if you take the M/O ratio and predict P/E, it closely tracks with the actual P/E from 1954 onwards. So what is the outlooks for equity markets?

*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.*

Hmm..So even if economy picks up, demographics to push equity markets down. But we know economy not going to do well. Hence, equity to be under pressure both ways.

Nice interesting linkage….Equity market trackers could develop this demographic ratio and use it as a variable to predict stock movements over a medium/long-term. Might help make better calls than all those fancy things like earnings/companies performance etc.

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