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TUESDAY a.m.
December 3, 2002
Demography and Bull Markets
By David Nichols
Using the last 100 years as a guide, you can empirically observe that multi-year bull markets are invariably followed by long periods where the market doesn't do very well.
This is why it is unrealistic to expect the glory days of the bull to return anytime soon. We'll undoubtedly see bull phases and bear phases that perhaps last as long as a year or two, but a trader's mentality is going to serve you well over the next period
Now, thanks to a study by three exceptionally clever finance professors -- and a mention in last Sunday's New York Times -- I've come across a compelling argument why these long-term bull and bear cycles happen.
It's all in the demographics.
These professors have identified a direct correlation between demographics and P/E ratios in the stock market. Reading their study, the broad-brush long-term trends of the stock market make a lot of sense. Better yet, their observations also hold up on the charts, as you'll see.
These professors have identified that people generally fall into 3 categories in their economic life: when you are young (20 to 39), you borrow and spend to build up equity. When you are middle aged (40 to 59), you save and invest for retirement. When you are older (60+), you start to cash in your investments and draw down your retirement savings.
It makes a big difference in your life whether you are part of a large group or a small group. The big story for our markets has been -- and will continue to be -- the fate of the baby boomer generation, which is enormously large compared to the groups that come before and after. The boomers number 79 million, with the generation before at 52 million, and the generation after 69 million.
These baby boomers always create a supply and demand imbalance in whatever phase of life they are in. It's tough to be a boomer! When they were young and looking to borrow, their demand for money drove interest rates higher -- this was the 70s. When they moved into the middle-aged investing years -- starting around 1982 -- their enormous demand for stocks created the longest-running bull market in history.
But now, as they approach retirement and begin to look to pull money out of the market, most of their gains are evaporating. Their desire to cash out stocks for retirement is creating a fundamental supply/demand imbalance towards lower equity prices. The generation behind, coming into their investing years, is not creating enough demand to pick up the supply of stock they want to liquidate for retirement.
Let's put it another way, as this may illustrate the point better. It's much better to go through life as part of a "small cohort", to use the professor's inimitable econ-speak. Let's take me as an example, as I'm part of the post-baby-boom generation (okay, I'm 36).
During my young, striving years -- when I'm likely to work hard and borrow -- interest rates have been extremely low and I can get my hands on very cheap money. As I approach middle age and look to invest, I can pick up stocks for the long run at lower prices. And as I approach retirement age, demand from the larger group behind me will drive up the price of my stock holdings, and I can eventually sell into the next bull market.
So when will this next bull market come? According to the professors, it won't be until 2018! It's going to take another 16 years -- until the "echo" baby boom generation hits middle age -- before stocks will again see a multi-year bull market.
Here's their chart of the ratio between those aged 40-49 to those aged 20-29. Using current information, this can be reliably projected out to 2030 or so.
![[Image 1]]()
And for the proof that their argument should be taken seriously, here is a chart of this same demographic ratio with the P/E ratio of the S&P 500 overlayed.
![[Image 2]]()
Extrapolating out to 2018, their conclusion is that P/E ratios are going to contract until 2018. P/E ratios should generally follow the downward slope of the ratio projection in the first chart.
If you want to read this very intriguing study yourself, you can click on the link at the begnning of the article, and download the paper from there.
It's not going to be a straight line down. Market timing is going to be more important than ever over the next 16 years. There will be plenty of opportunities to make money -- just like the corresponding period from 1966 to 1982. You will just have to be flexible in your outlook.
This also brings up a point I've made about the doctrinaire bears, who expound endlessly how P/E ratios must return to historically low levels before we have another bull market. Well, they're probably right, and this is usually true. But they may have to wait a very long 16 years to be proven right.
It's better to loosen up and go with the flow in the meantime. This study does not change my expectation that we could be in for a very nice period over the next year or so, where stocks make a nice, sustained move to the upside. But over the really long-term -- the next 16 years, apparently -- it's likely that we will be going both short and long with regularity.
Uptrend put on notice
Yesterday's big sell-off on the 10:00 am ISM manufacturing number put the bulls like us on notice that the end of this uptrend is perhaps at hand. The market roared at the open on good retail sales from the long weekend, but the weaker ISM number stopped the party cold.
The market is now in a mood to react to bad news. That's our warning shot.
![[Image 3]]()
On the sentiment dashboard, the trend confidence clicked down to 3 in the mid-term, and the gauge slipped backwards a bit. If it moves back much further, it's going to flip over into a downtrend.
Accordingly, it is now likely that we will elect to exit all bullish positions in the Rydex Funds at some point over the next few sessions. I will send out an update by early afternoon to all Alert subscribers if I get confirmation that it is time to exit these positions.
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