What Really Moves the Stock Market? — Demographics
Let me ask you a question: Do you believe that stocks go up in the long run?
Because it’s what you’ve been told by the financial establishment? Because it has always been true?
Does that seem like a good enough explanation to you? Good enough to bet your financial future on?
If you’ve always felt uneasy about those questions, today’s Daily Reckoning Australia is for you. If you haven’t worried about this before, you will shortly. Because you need to.
I believe stock markets in the developed world are likely in for an indefinite bear market. I’m talking about a steady downtrend in stocks, for the rest of your lifetime.
Probably punctuated by a crash or two. And the occasional bear market bounce, of course.
If that sounds absurd, please keep in mind it’s considered completely normal in the country where I’m writing this. After all, it has happened here. The stock market is down about 27% over the last 32 years…
And that’s after a bear market rally of almost 400% since 2009…
Tell a Japanese tax accountant that people in the West believe ‘stocks go up in the long run’ and you’ll get a bewildered look. Or a sad one. A neighbour committed suicide over her stock market losses…
If you agree with my predictions of demographic doom for the stock market, does that mean you should close your brokerage account and run for the hills?
No, it just means you need to be more careful about which stocks you invest in. The broad and diversified strategy of holding an entire index is what’s at risk of trouble, in my view.
So, let’s dig into why I’m making these bold claims…
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The real reason stock markets move
What if investments don’t inherently go up in the long run? What if there’s a very specific reason this only appears to be true in the past?
A reason that will end and reverse for the first time in human history. With only one exception — a place where the demographic change playing out in the developed world now has happened already.
A place that delivered precisely the stock market returns I’m predicting — an indefinite bear market punctuated by crashes and bounces.
Unlike my peers in the ‘stock markets go up in the long run’ camp, I can explain to you precisely why stocks move the way they do. Not with mantras or feeble explanations about the past. Or theories about returns and risk premiums.
My prediction is based on a simple fraction, or ratio, that explains the stock market’s booms and busts. It uses maths that is set in stone decades in advance, making the stock market predictable. But, most important of all, my method analyses the only true determinant of stock prices in a way that is incredibly simple. It’s common sense. And it trumps all other considerations.
For today, I want you to grasp the intuitive nature of my claim with a simple explanation.
Let’s start with the basics…
Stock prices are determined by supply and demand
Shocking, I know.
But the idea that investment prices are determined by supply and demand, as are all other prices, is heresy in financial markets. Financial advisors will tell you about intrinsic value and point to charts of never-ending gains over time.
They’ll talk about efficient markets correctly pricing assets based on their risk premium. (The greater the risk, the greater the return.)
Or they’ll tell you about how dividends and returns compared to interest rates determined stock values. That’s the version I learned at Goldman Sachs.
But supply and demand are never mentioned in the investment world. Instead, the focus is on value. And the presumption that value and price converge, more or less, over time.
But I don’t care what they say. All prices are determined by supply and demand, not value. Investments are no different.
It’s just that the balance between supply and demand in the stock market has never before been upset in the way it will in coming years. Which clouds the issue if you favour looking at the past instead of using logic and reason.
If stocks have always gone up, why bother explaining it? Let’s punt the nation’s pension savings on the assumption instead, with compulsory Superannuation.
Well, what if the factor, which has ensured markets always go up, will change for the first time? Then stock markets might stop going up in the long run.
How demographics control stock market prices
Something academics call the life cycle hypothesis explains how demographics control stock markets over time. It lays out what constitutes the supply and demand for investments.
The hypothesis is very simple: You buy investments when you’re middle-aged. And sell them when you retire.
This is especially true in the modern financial system. People simply plough a portion of their hard-earned money into the financial markets each paycheque. It happens automatically for most of us.
That’s the demand side of things — the investment buyers.
What about supply — the investment sellers? Well, that’s determined by age too. In retirement, people sell their investments to fund consumption. They want out. They don’t pay attention to whether the stock market is overvalued or not. They have bills to pay!
In fact, a downturn in investments forces retirees and their pension funds to sell even more assets to cover the same living expenses. Simple reality and basic human need contradict the theories of finance and their ‘efficient markets’.
Do you see how the overall demand and supply of stocks is determined by the size of age cohorts? The number of middle-aged workers (investment buyers) relative to the number of retirees (investment sellers) determines the demand and supply of investments.
The good news is demographics are predictable. The number of buyers (demand) and the number of sellers (supply) is easily calculable and known in advance.
Therefore, you can predict the supply and demand for stocks. And that allows you to make reasonable predictions of prices in financial markets. At least their direction over longer periods of time.
Of course there are many factors at play. And this thesis only holds over long periods of time. But don’t forget, prices are set by supply and demand in the end.
So, what do demographics predict is in store for the supply and demand of investments? Well, you’ve been hearing about the ageing population, right? That means the amount of sellers of investments is growing. Importantly, it’s growing faster than the amount of buyers. And that bodes ill for stock market prices.
As the baby boomer generation retires, it’ll attempt to sell its vast horde of investment assets to pay for retirement. But to whom? There aren’t enough young people to absorb them.
That’s my contention, anyway. And it’s predicted by declining M/O ratios — the ratio of middle-aged people to old age people. The ratio of investment demand to supply. As it falls in coming years in developed economies, this means the supply of investment assets will rise relative to demand. And that means lower prices.
Stocks will stop going up in the long run.
Until next time,
Editor, The Daily Reckoning Australia Weekend
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