Why Demographics Tell Us the Market Will Fall
Sideways to Down for 20 Years?
The Predictability of Randomness
Knights to the Rescue
How to Know You Are On a Roll
By John Mauldin
As we come to the close of the year, my Christmas gift to you is an
analysis of some very interesting research on the connection between
demographics and the stock market. It falls in line with much of our
recent investigations, and adds a further piece to the puzzle as to
where the eventual bottom of the stock market lies and when we might
get there. For most investors, knowing where the stock market is
going and when it will get there might be useful. Then I show you
how you can get involved in the War on Terror from the comfort of
your living room, while saving lives and helping the good guys.
I have written about the connections between age demographics of the
population and the stock market on several occasions. I do not buy
into Harry Dent's theory he espoused in his book The Roaring 2000's
that the stock market is going up until the Baby Boomers start to
retire in 2007. He makes connections between charts and numbers that
I do not feel are warranted.
But he is certainly not wrong that there is a strong correlation
between age and buying and saving (investing) preferences. Dent's
mistake is in assuming that because Boomer's will be saving until
2007 that the stock market will be going up as well. There is a
certain appealing logic to this, but unfortunately there is no
statistical correlation. As Rob Arnott's study shows, the actual
underlying correlation for much of the apparent connection between
the boomer generation and the stock market can be found in the ratio
of children, workers and retirees. (I discussed this in detail in my
November 15, 2002 e-letter, Will You Be Able To Retire? You can
click on the link, or go to the archives at www.2000wave.com .)
Now we find a rigorous academic study which shows a further strong
correlation between age demographics and the Price to Earnings
ratio. This paper is by three rather well known economics professors
writing for the Cowles Foundation at Yale. (John Geanakoplos from
Yale; Michael Magill from University of Southern California; and
Martine Quinzii from University of California, Davis.)
The importance of this study is not that it gives us some new
startling conclusion. It corresponds quite well with research and
observations by Michael Alexander in his book Stock Cycles, among
others. What this paper presents is a model of how and why the
changes in the age demographics influence stock market prices. It
takes us from the world of anecdotal or inferential evidence into
more solid statistical basis for prediction. It moves us from the
intuitively obvious (guessing) to a place where we can be more
confident about our assumptions. When combined with the half-dozen
other studies I have written about on this topic, it makes me much
more comfortable that my opinion that we are in a long term secular
bear market is accurate. (You can read about those studies in the
draft chapter on secular bear markets at www.absolutereturns.net)
The Predictability of Randomness
Quoting from their introduction (with my added emphasis):
"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. For the 40 year cycle in population pyramids, gives
rise to a 40 year cycle in equity prices-and the prices, although
random, have a strong predictable component."
Essentially, the authors create a fairly complex mathematical model
of the economy. They note that based on earlier studies, there is a
demonstrable difference between how young workers spend and invest
and how older workers spend and invest. Further, there are
differences in income. They take into account business cycle shocks,
output fluctuations and how much risk tolerance or aversion each
generation has.
"Because the typical lifetime income of an individual is small in
youth, high in middle age and small or nonexistent in retirement,
agents [that's us - John] typically seek to borrow in youth, invest
in equity and bonds in middle age, and live on this middle-age
investment in their retirement."
This is a well-known lifecycle of an investor, but it has an
important role to play: "....this lifecycle portfolio behavior
implies that the relative size of the middle and young cohorts,
which can be summarized in the medium-young cohort ratio, plays an
important role in determining the behavior of the equilibrium prices
on the bond and equity markets.
In simpler terms, they divide the various age groups and generations
into "cohorts." They vary the birth rate of each cohort to show baby
booms and baby busts. The ratio between young generations (or
cohorts) and middle-aged generations is something the call a MY
ratio. (Middle-Young) When you factor all the variables, apply
different sets of economic assumptions, subject the model to
"shocks" (such as the 1973 Oil Crisis) and so forth, the outcome is
still the same: there is a strong correlation between the ratio of
young and middle workers and the price to earnings ratio.
Indeed, when you overlay their MY ratio with the P/E ratio on a
chart, it appears that the MY ratio is now the "trend" to which the
P/E ratio is invariably brought back.
Thus their model predicts that the P/E ratio will drop from the
current 30 or so to somewhere between 5 and 16 in the next 20 years.
The wide range is because of different assumptions. If you make
fairly optimistic assumptions, you get 16. If you are pessimistic,
your assumptions might lead to the model showing 5. But a drop to 16
is a very dramatic one.
This is different than simply saying, as Robert Shiller does, that
P/E ratios always revert to the historical mean, which is about 15.
This paper suggests there is a fundamental reason for that
"reversion to the mean": the age ratio between generations.
You can read the paper for yourself at
http://cowles.econ.yale.edu/P/cd/d13b/d1380.pdf.
Sideways to Down for 20 Years?
Now, let's look at some implications. First, remember that average
actual corporate profits grow at roughly GDP plus inflation. That
has been roughly 6%. That means profits double every 12 years. Let's
take an optimistic view that the economy is going to really rebound
this year and the P/E ratio of S&P core earnings next year will be
30, rather than the current 45 or so.
That means that if the P/E ratio drops to 16, it will be 12 years
before the market permanently rises from the levels at which we are
today. You don't even want to do the numbers for what happens if the
P/E ratio drops to 5.
Will the market go up next year? The model is not that precise. As
Alexander shows, the price movements from one year to the next is
pretty random. All this paper tells us is that sometime over the
next 15-20 years, there is going to be a fundamental shift to the
downside in the average P/E ratio. This means that the market moves
sideways for a very long time until the P/E ratios come into line,
or that the market drops at some point.
Other work I have written about suggests that markets will move down
in concert with future recessions during secular bears. It is
reasonable to assume that we will have several recessions over the
next 15 years, so one could expect a long drawn-out secular bear.
Not a pretty picture for index fund and buy and hold investors. But
it is also a market with different types of opportunity for more
nimble investors and those with a willingness to think outside of
the buy and hold box.
Knights to the Rescue
Now, let's switch hats and think about those whose worry is not
where the markets will be in 20 years, but if they will live to
2004. I am personally associated with a group of very dedicated men
who take food and medicine to people who live in places which can
only be considered dangerous, and are usually not able to get help
from established relief groups. If the thought of getting an
adrenalin rush when you are saving lives is appealing, these are
your type of men.
They were among the first into Afghanistan, long before our troops
went in. I got a call one afternoon last year from Ed Artis just
after they were awakened by carpet bombing from B-52s only a few
miles from their camp where they were delivering food into the
northern mountain tribes. Ed was able to get his team, a large
convoy and guards in as fast as he did because he had been into
Afghanistan several times in the past years, bringing food and
medicine before anybody cared about the country. (They carried
satellite phones and kept the proper officials notified of their
whereabouts. From time to time, it was "suggested" they move to
another area.)
You may have heard about Ed and Knightsbridge. They were a recent
subject of a lengthy National Geographic documentary, showing the
work they did. Ed was the one helping pull the shrapnel out of the
journalist who received a great deal of publicity over here.
They have rescued nuns in Rwanda during the killing rampage (one of
my favorite stories). They jump out of airplanes with food and
medicine. They slog through jungles in Myanmar (the old Burma) to
take food and medicines to the Christian tribes which are persecuted
by the government. I mean they literally smuggle the food in on
donkeys under the cover of the jungle. If they get caught, there is
not an embassy to ask for help. They take food into Cambodia for
refugee tribes that no one, including to our shame the US
government, wants to acknowledge. Nicaragua, Cuba, Chechnya; they
go where the normal relief agencies have trouble getting in, or it
is considered too dangerous. The standard is simple: if there are
women and children suffering, and the normal relief organizations
cannot for some reason get in, they try and find a way to help.
They do this under a non-profit organization called Knightsbridge
International. During the Crusades, the Knights of Malta ran
hospitals along the Crusade routes, and were involved in other acts
of charity. Ed and the members of Knightsbridge try and keep the
ideal of service to mankind as embodied in the original code of the
Knights of Malta alive in today's world: "...to aid those less
fortunate than I, to relieve the distress of the world and to
fulfill my knightly obligations."
Ed and the rest of the team take no salaries. The entire group is a
volunteer outfit. If you go with them you pay your own way. They get
medicine and medical equipment donated, raise the money for foods
and transportation, and then they take the food and drugs directly
into the various countries.
They are now working in an area of the Philippines where terrorists
have been operating. They have a large supply of medicine, X-ray
equipment, dentals labs and other critical items they need the money
for which to pay the costs of air transportation to take them to the
country. This will literally mean the difference between life and
death for the people in this area.
They will be going into other places I simply cannot talk about in a
public forum. To do that, they need your help. Your donation will
save a life somewhere. You can go to their website and see where
they have been and where they are planning to go. These are mostly
places of terrorism, repression, poverty or need. While some of what
they do is not as spectacular as a dawn bombing run in Afghanistan,
the need they find everywhere is personal: it is one human being who
needs help to survive.
During this time of year, I urge you to send a check to
Knightsbridge International. You know you need the tax write-off.
Make it a large one. Ed Artis, Walt Ratterman, Jim and the others
are the really good guys. They are slightly insane, but they are
really great people.
You can send your check to:
Knightsbridge International
Post Office Box 4394
West Hills, California 91308-4394
You can learn more about Knightsbridge at www.kbi.org . If you are
interested in going on a mission, and have some skill or area of
expertise that is useful in relief work, drop Ed a note.
Next week, I will do a shorter e-letter before leaving for Puerto
Vallarta for a much needed vacation. My good friend Bill Bonner of
Daily Reckoning fame has agreed to favor us on January 3 with some
of his insights from the book he is finishing up on the similarities
and differences between the US and Japanese markets. This is going
to be a great book, and I can't wait to get it in my hands. I will
come back refreshed from PV and write my 2003 predictions.
How to Know You Are On a Roll
I am somewhat worried though, that I might have used up all my
predicting skills (read luck). This week I studied for the test for
a principal's license (Series 24). I took a two day class and then
took one practice exam after another until I felt I had it down.
Yesterday I took the test, and as I finished, I was sure I had
failed. It was the hardest securities exam I have taken. There
seemed to be very little relationship between my study materials and
the test. I readily acknowledge guessing on at least 40-50% of the
questions.
I was pleasantly shocked to find I had scored 80. I called my wife
and told her to meet me at the airport. When she asked why, I told
her we were going to Vegas, because I was on a roll. I am not sure
what the odds are for my getting so many answers (guesses!) right,
but I am sure they are high. I am still shaking my head.
I hope I still will be on a roll when I have to guess about the
markets and economy in a few weeks. The last few years have been
good in terms of most of my predictions, and I would like to keep up
the good run. It always come to an end, but I would like to keep it
going for another year. I just wish the choices came in a multiple
choice test. It seems I have a knack for them.
For those of you who sent resumes for my editing/writing/research
position, I will try and get a note to you before I leave, but will
focus on the topic after I come back. (For more details see the end
of last week's letter.)
There is still room in our foursome in Puerto Vallarta if you are
there over the New Year Holidays. Drop me a note, and I will give
you the details, and we can arrange to meet. I will also be in Palm
Beach in late January, and will be able to meet with clients and
potential clients at that time. (for more information, go to
www.accreditedinvestor.ws .)
This year, all seven kids will be home and at the table on
Christmas, which gives Dad a special feeling. You can see my kids
(my family is a tad more colorful than most) by going to
www.johnmauldin.com and clicking on "Who is John Mauldin?" and then
the family pictures. The web site my kids gave me this year for
Father's Day will give you an idea of why I am such a happy guy.
Life is good, we are Blessed, and let me wish you a very sincere
joyous Christmas from my family to yours.
Your can't wait to see the next Lord of the Rings episode analyst,
John Mauldin
[email protected]
Copyright 2002 John Mauldin. All Rights Reserved
If you would like to reproduce any of John Mauldin's E-Letters you
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