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.
Given the rise in U.S. equities since they bottomed out in 2009, combined with increasing numbers of Boomers entering retirement, this investment theme has not played out, at least over the last five years. 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?” It was in this report that Liu and Spiegel introduced the concept of the “M/O ratio,” a statistical model in which the P/E ratio depends on a measure of age distribution. In short, an aging workforce means increasingly lower equity valuations.
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:
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.
The report also looks at the developing markets and concludes that the correlation between M/O and P/E are a “mixed bag.” Korea has a negative correlation while China has a similar correlation to the U.S., but only half as strong. Their conclusion is that “it is unlikely that the strong relationship between demographic patterns and equity valuations that we have identified for the United States can be extended to the rest of the world.”
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.
The fact that the other G-7 countries (as well as many of the developing markets) do not show nearly as strong a positive correlation between M/O and P/E as the U.S. should cast some doubts as to whether, on a going-forward basis, this theory still holds true for the U.S. market. However, it certainly would seem to add weight to the importance of global diversification. In addition, the theory certainly belongs on the negative side of the scales as money managers and advisors consider their equity/debt allocations.
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. For many may have a sentiment similar to that expressed by Will Rogers, who famously said, “I like a return on my principal, but mainly I like the return of my principal.”
