The Demographics of Stock Investment
July 6, 1999
"Demographics support an ongoing Big Shift of household financial assets into equities
- and does so for another dozen or more years."
Edward Kerschner, Paine Webber Investment strategist, WSJ 07/06/99 p C1
Wonder if he is right! Has he done his homework, or is he just eyeballing it?
I begin this statistical exercise with a bias that many of the things discussed in the financial media concerning stock valuations - things such as earnings, interest rates, etc - are not predictive of long term trends.
Rather, the critical element in determining stock prices is financial flows - money flowing into stocks versus money flowing out. The bull market of the 1980s and 1990s has been propelled by demographics. A huge cohort of "baby boomers" born between 1945 and 1964 began reaching age 35 - an age at which serious saving and investing typically begins - in 1980. Two years later, the great bull market began.
The demographics of the baby boom have driven the dividend yield on the S&P 500 down to 1.2%. A retiring boomer with a $1,000,000 account will receive only $12,000 per annum in dividends. For Boomer stockholders to live at anything like their current lifestyles, they are going to be net sellers throughout their retirement years.
The question is, when does this process begin?
In the past, I have speculated that selling pressure from retiring boomers will not be felt until about 2007. But is that accurate?
First, a few facts.
The typical corporate retirement plan allows early retirement at age 55 with full vesting. Defined benefit plans also typically allow early retirement at age 55 with significant subsidies for early retirement. Because of favorable reduction factors, the early pension has a greater present value than the normal retirement benefit typically provided at age 65.
For purposes of funding, the typical corporate defined benefit plan assumes an average retirement age of about 58 years. This means that the average dollar of pension liability walks out the door at age 58.
The earliest age at which Social Security benefits are payable is age 62. The average age at which Social Security benefits actually commence is age 63.5.
So the question is, when does the ratio of Americans aged 60 through 64 begin rising relative to the working age population age 35 through age 60.
As a first stab at this, I gathered the Census Bureau 1999 population projections by age for 1996 and later years. Although the Census Bureau provided projections through 2010 for ages 60 to 64, the nearest to a working age population that they provided was the age 15 to 45 group.
As the table below demonstrates, the age 60 to 64 group grows relative to the 15 to 45 group in every year, with a marked accelleration beginning in 2001, and an even steeper accelleration starting in 2005, when the oldest baby boomers hit age 60.
|Year||Age 60-64||Age 15-44||Ratio|
But I was disturbed by the fact that the Census projections in the above table showed the ratio growing even in 1996. I was expecting to see a decline in this ratio throughout the 1990s market rally.
I suspected that the 1999 Census projections might be distorted by immigration, and in particular, the addition of a million or more minimum wage persons each year who will not factor into the stock market investment equation over the next 10 years.
Further, I found the totals for the age 15 to 45 group puzzling given the low mortality of this group and the huge legal and illegal immigration of nearly 2 millions per annum. The stagnant number of from 119 to 120 millions each year implies huge out-migration from the United States or far higher mortality than any reasonable mortality table would show.
Therefore, I decided to obtain the raw 1990 census data by 5 year age groups, and then adjust that data forward for the next 20 years, reducing the number in each group each year by the healthy female mortality from the PBGC tables published under section 4062 of ERISA for the oldest year in the 5 year group. This amounts to a unisex mortality assumption of the female table set forward 2.5 years. It should be an excellent assumption for the portion of our population that invests in common stocks and mutual funds.
The table below presents the results of that study for each year from 1990 through 2010, providing the ratio of ages 60-64/35-59, 60+/35-59, and the ratio of 60+/25-59.
As I had guessed, all three ratios declined throughout the 1990s, indicating upward pressure on savings and stock prices. The low points for each ratio, 1999, 2000 and 2000, respectively, are marked with asterisks on the chart below.
|YEAR||Ratio of ages
60-64 to 35-59
|Ratio of ages
60+ to 35-59
|Ratio of ages
60+ to 25-59
|ICI Stock Mutual
So does this mean that the market will turn?
Absolutely, and no later than September of 2003.
The exact timing of when retiree selling will begin to effect price depends, in part, on the dynamic effects of today's high prices.
What happens when people win $20 million in the lottery? Uniformly, they find a reason to quit their jobs within a few months after winning. Wealth makes people retire earlier.
Thus, the enormous wealth generated by this historic bull market could be provoking early retirements in sufficient number to affect cash flows into stocks right now.
In fact, the narrowing of the market signaled by the topping of the NYSE advance-decline line in July of 1998 might be the first indicator of declining liquidity. Despite the new record highs in the popular indices, fewer and fewer stocks are particpating. The fall in mutual fund inflows in 1998 over 1997 might also be an indicator, but I would reserve judgment on this because of the August, September 1998 price decline.
The practical answer is that from now through May, 2002, each of you should be invested in stocks and mutual funds from Nov 1 through April 30, and out of the market entirely from May through October of each year. But beginning with May, 2002 onward, every time the market gives a 10-week rsi oversold reading and signals a momentum loss, you should invest in a short fund such as Prudent Bear (BEARX), Rydex Ursa (RYURX), Rydex Arktos (RYAIX) or Fleckenstein's fund. Before 2010, there will be 2 or more spectacular declines that will make you nearly as much money as you could have made riding the S&P up from 1990.
The question, then, is what could make cash flows into stocks slow down even before retirement selling begins in earnest?
To answer that question we must first explore what those flows are.
Below is a chart showing the sources of supply and demand for Corporate equities from the Federal Reserve's Z1 releases from 1990 through 1998.
First the demand:
Notice that the biggest source of expected demand, households, is in fact the biggest source of supply.
And now the traditional sources of supply:
Notice once again that Corporations are the normal source of supply. Corporations are supposed to issue new stock and use the stock market as a source of capital. Now they are doing the opposite. They are buying back their stock, net of new issues, in record quantities at record high prices.
The two charts above scream at anyone willing to see and think. What we have is the household sector (consisting of founders, executives selling stock acquired on exercise of their stock options, and retirees selling long held stocks to support themselves in retirement) disposing of stock at unprecedented rates.
What you see above is a massive inter-generational transfer of cash from the Baby Boomers and the Corporations that employ them to founders, option eligible executives and to wealthy retirees.
A cynic would argue that the executives are looting their corporations of cash to prop up the value of executive options. In the high tech sector, companies sell puts on their own stock and buy calls, all on inside information. They use the proceeds to finance stock buy-backs, thereby forcing the call writers to cover. Dell has raised over $3 billions in the last two years playing this game. Microsoft does it too. All growth funds need do to out-perform the market is track option prices and volumes on these tech stocks and buy when puts are plentiful and cheap. After all, the biggest writer gets to peek at the company's order book!
It is unprecedented in human history.
I should note parenthetically, that the above tables should also make clear why new companies (less than 15 years of public trading) will outperform old ones heavily owned by 80 year old widows.
The $500 billions of cash being pulled from the market each year is an enormous amount of money. Can it countinue? Which sources of inflow are the least stable?
The answer is relatively obvious. The $267 billions in corporate buy-backs are the least stable flow. These corporate buybacks of listed companies exceeded profits net of taxes and net of dividends for 1998 of all corporations by $55 billions. Public corporations are borrowing money to buy back their stock. A recession would crumple the buy-backs. So will rising interest rates driven by rising inflation.
The increasing popularity of corporate buy-backs from 1994 through 1998, the truly manic phase of this bull market, tells us that the most manic and optimistic of all investors are the CEOs of public corporations.
In August and September of 1998, corporate CEOs stepped in massively and bought in the face of the sell off. In the Q3 they bought at a $308 billion annual rate and in Q4, at a $491 billion annual rate. They did it because their own businesses looked reasonably good and interest rates were plunging to record lows. Borrowing to finance buy-backs was cheap.
It was the CEOs of the fortune 500 who bailed out the stock market in 1998. Alan Greenspan was only a bit player who encouraged the banks to lend them the money to do it.
They are the wild optimists, and anything that sours their mood will cause a quick spill in the market. A rising dollar - rising interest rates - a serious economic slowdown - banks worried about declining credit quality, any of these could cause CEOs to become much more cautious about buy-backs.
The CEOs will continue this behaviour only if they think that it will produce a higher market and higher option values later. If they become convinced that the market is headed down, they are not about to throw good money after bad. Given the incentives, they buy high and sell low.
Recognize the enormous leverage in the flows. We have $500 billions in supply at these prices. If demand from buy-backs disappears, we have a $200 billion or so deficit in demand. Prices would have to fall a long way to bring the $500 billion supply down to equal that lower demand.
Ultimately, the stagnant work force projected by the Census department, and the swelling number of retirees with stock to sell will put an end to the corporate buy back game. Once the corporate CEOs recognize the demographic reality, they will not even try to prop up their stocks. Instead, they will begin to respond to retirees calls for higher cash dividends, persuade their consultants to begin pushing cash bonus plans tied to dividend increases, and lobby to have cash salaries in excess of $1,000,000 made deductible to the corporation once again.
Until then, investing is a game of guessing at how optimistic the corporate CEOs are.
Upon seeing the above two tables, I began to realize how anomalous the fund flows must be from a historical perspective. Markets simply could not function at all over the long term with the normal sources of supply and demand reversed in this way.
And the thought of asking corporate employees to put their retirement savings into stocks priced by such unsustainable flows seems criminal.
We have lots of excellent studies on the net analyzing the market in terms of PE ratios, price to book ratios, price to sales ratios and similar measures. For one of the best see Alan M. Newman. We have excellent valuation models like the federal Reserve's own model which you can see at Dr. Ed Yardeni's Economics Network. An excellent historical PE range chart can be seen at Decision Point.
But excessive valuations have had no predictive value in this market.
This is a new era all right. But the newness has nothing to do with technology, the internet, valuations or inflation. It is a new era because money flows have been warped beyond recognition.
And to see how truly unique the 1990s have been, I prepared a similar chart of demand and supply from the nine years of 1954 to 1962, a period of dramatically rising stock prices.
First, a picture of typical bull market demand flows:
And now a more typical picture of bull market supply.
In the above charts, capital markets operate as we expect. Households buy stock and corporations issue it.
The truth is that the stock market can only operate as an inter-generational cash transfer mechanism during periods when we have a falling ratio of retirees to workers.
As soon as a static or declining pool of workers detects selling pressure from retirees in the form of flat or falling prices, they will stop investing until dividend yields compensate them for the risk of rising retiree sales. Once Joe SixPack goes on strike, the buy-back bravado of the CEOs in the face of market sell-offs will quickly disappear.
Don't expect foreign investment dollars to bail out our stock market. Indeed, the demographics for the G7 nations are worse than ours. See the graphs at the end of Urban Institute Research Paper.
Back to Money and Markets Page
(c) 1996 Yggdrasil. All rights reserved. Distribute Freely.