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Why Demographics Tell Us the Market Will Fall

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

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

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.

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"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

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.

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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: " 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.

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You can send your check to:
Knightsbridge International
Post Office Box 4394
West Hills, California 91308-4394

You can learn more about Knightsbridge at 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

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 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 Thoughts from the Frontline
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