Thursday, October 28, 2004

Will Baby Boomers drive down stock prices?

For about as long as I can remember (which some days is a few hours ;) ) I have wondered what would happen when the so-called baby boom generation retires and starts withdrawing money from the stock market. Will they depress the stock market? Should I save more as a result?

Geanakoplos, Magill, and Quinzii provide an interesting look at this question and their findings suggest that those of us behind the baby boomers had better plan on saving more than we would otherwise and assuming lower returns in all future value calculations.

A few highlights from the paper:

"Agents have distinct financial needs at different periods of their life, typically borrowing when young, investing for retirement when middle-aged and disinvesting in retirement. The stock market (along with other assets like real estate and bonds) is a vehicle for the savings of agents preparing for their retirement. It seems plausible that a large middle-aged cohort seeking to save for their retirement will push up the prices of these securities, while prices will be depressed in periods where the middle-aged cohort is small. "

Which translated to a language that my classes would better understand is that when there are fewer surplus spending units (SSU), the market will fall.

Interestingly the authors show that this price cycle could occur even if market participants were aware of the changing demographics (I confess that I am not sold on this part of the paper).

"Poterba (2001) has argued that if agents were rational, they would anticipate
any demography-induced rise in stock prices twenty years earlier, bidding up the
prices at that time, thereby negating much of the demographic effect on stock
prices. We show that if agents were myopic, blindly plowing savings into stocks
when middle-aged, then stock prices would be proportional to the size of the
middle-aged cohort. When agents fully anticipate demographic trends, their
rational response actually reinforces the effect on stock prices, making its
rise more than proportional to the size of the middle-aged cohort."

Which means that when baby boomers retire, we should expect stock prices to fall.

In investigating this relation, the authors also improve our understanding of the equity risk premium (the measure of returns greater than the risk free rate of return). In their words:

"Previous work has suggested that the equity premium observed historically is
difficult to reconcile with a rational expectations model on two counts. First,
the historical equity premium is too large to be rationalized by reasonable
levels of risk aversion (Mehra and Prescott (1985)). Second, and most important
for us, the observation that young people are more risk tolerant than old
people (Bakshi and Chen (1994)) suggests that the equity premium should be
lowest when the proportion of young people is highest, exactly contrary to
the historical record."
"Our stochastic model sheds some light on the second problem. If there is a
strong demographic effect, then the numerous young (and contemporaneous few
middle aged) should rationally anticipate that investment returns will be
relatively high. Since wages and dividends do not vary so dramatically with
demographic shifts, they should anticipate that a relatively high fraction of
their future wealth will come from risky equity capital values. Though
the average risk tolerance is higher, the average exposure to risk is also
higher, and so we find that in our model the equity premium is higher when the
stock market is low, consistent with the historical record."

Get that? It means that because of the greater TOTAL exposure, the effective equity risk premium is greater for young investors. Thus, when young investors are more numerous (and consequentally the market prices are low since there are relatively fewer middle-aged investors, the equity risk premium should be HIGHER! Which fits the evidence and helps to explain why risk premiums were low during much of the 1990s.

I think that deserves a WOW!

1 comment:

Anonymous said...

The effect here would seem to be a compression of price earnings ratios. A company's earnings are not affected by masses of boomers retiring and selling the stock.

PE ratios are now at the high end of their historic range at a level that has seldom launched bull markets and often led into prolonged stagnant or bear markets.

This may be just another way of looking at the same data and seeing the same result: Stocks will go down over the next decade (?!) or whatever time is required to get PE ratios down to the levels where bull markets are launched (about 8 - 12 in these modern times, I would think).

A mitigating factor is that dividend payouts will become more important to compensate investors for lower rates of stock price appreciation. Companies will be forced to share their earnings and cash hoards as PEs decline. Microsoft has already run into this effect.

I would fault the study for being entirely U.S. centric. The boomers and the following cohorts aren't limited to either U.S. markets or U.S. traders.

Investors outside the U.S. are going to find U.S. stocks more attractive as the PE ratios move down to more realistic values.

Investors in the U.S. will find attractive stock markets in other parts of the world. Half of my stock and bond investments are outside the U.S. in places I hope are counter trend to U.S. demographics. Look for young populations and growing economies, Asia ex Japan for example.

Think globally, act globally.