Looking at the population can give investors long-term insight into what big trends to follow and which to ignore, writes Jim Fink of Investing Daily.

Recently, I wrote about author Harry Dent and his use of birth rates and life cycles to determine when aggregate consumer spending is rising and falling.

Dent’s theory that consumer spending is a leading economic indicator of stock prices makes intuitive sense, but his performance track record demonstrates an inability to translate economic theory into investment profits.

Some readers took issue with my treatment of Dent’s demographic investing theories, arguing that demographic trends are long term in nature, whereas stock-market fluctuations can be influenced by a countless number of short-term and ephemeral factors. I completely agree...and let me reemphasize my belief that using demographics in investing makes a lot of sense.

Indeed, many investment strategists use demographics to make stock-market forecasts just like Dent does. One example is Toronto-based David Rosenberg of Gluskin Sheff, an economist who keeps track of the 45- to 54-year-old demographic, which is a slightly larger group than Dent’s 46 to 50 demographic. In August 2010, Rosenberg noted the following:

The 45-54 year old cohort has the lowest savings propensity, the highest earnings level, and the greatest increase in net worth compared to other age categories. From 1984 to 2010, this cohort rose each and every year.

That didn’t prevent business cycles from occurring or the odd vicious bear market, but over that period, the stock market, in constant dollar terms, advanced 240%. But starting next year, this key age cohort for both the economy and the markets will begin to decline each and every year to 2021.

The last time we saw sustained declines in this part of the population was from 1975-83, which was an awful time for both the economy and the S&P 500 which, in real terms, was as flat as a pancake and real per capita income barely expanded.

Analyzing birth rates and consumer spending to forecast corporate profits is only one way to use demographic analysis to predict stock prices. Another way is more technical in nature, and looks at supply and demand for stocks.
For example, in August 2011 the Federal Reserve Bank of San Francisco issued a report on the negative effect the retirement of the baby-boom generation (born 1946 to 1964) will have on the demand for stocks, and consequently, stock prices:

Historical data indicate a strong relationship between the age distribution of the US population and stock market performance.

A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.

To measure the degree by which the US population is aging and retiring, the authors utilize a metric called the “Middle-/Old-age ratio,” which divides the number of people aged 40 to 49 (prime earnings and spending years) by the number of people aged 60 to 69 (retirement age with declining spending).
It turns out that between 1954 and 2010, this M/O ratio was highly correlated with the P/E ratio of the stock market—when the M/O ratio rose stock valuations (as measured by P/E ratio) also rose, and when the M/O ratio fell stock valuations also fell:

Between 1981 and 2000, as baby boomers reached their peak working and saving ages, the M/O ratio increased from about 0.18 to about 0.74. During the same period, the P/E ratio tripled from about 8 to 24.

In the 2000s, as the baby-boom generation started aging and the baby-bust generation started to reach prime working and saving ages, the M/O and P/E ratios both declined substantially.

According to the SF Fed, the decline in the M/O ratio has just begun, and will continue to decline until 2025! The stock market’s P/E ratio will fall in unison from its current 16 times earnings to only 8.3 times earnings, a 48% decline.
In other words, in 2025 investors will value $1 worth of earnings 48% less than it values $1 worth of earnings today. So, the average stock with earnings per share of $1 is valued today at $15, but will be valued at only $8.30 in 2025 if its real (i.e. inflation-adjusted) earnings remain the same.

Of course, the US economy typically grows in real terms, and so do corporate earnings. The Fed authors expect real earnings to grow 3.42% annually over the next decade.

Yet the M/O ratio will decline so much that the resulting reduced P/E ratio will overwhelm the growth in real earnings and cause stock prices (in real terms) to decline by 13% between now and 2021. No wonder some smart investors, like PIMCO bond king Bill Gross, like bonds more than stocks!

Between 2021 and 2025, the M/O ratio will continue to decline, but at a much lower rate, so that real earnings growth will be sufficient to allow real stock prices to grow slightly. But no big stock rally will occur until 2025, when the M/O ratio stops declining.

Depressing stuff. On February 10, investment bank Credit Suisse issued a report on demographics and asset prices that reached a similar conclusion to the earlier SF Fed report. The only difference is that the Credit Suisse analysts are even more pessimistic than the Fed, and project the stock market’s P/E ratio to fall even harder into 2025—down all the way to 5.2 times earnings, which would be a 68% decline.

Low PEG Ratios Are the Solution
My takeaway from all this gloom is that the only way to make money in the stock market over the next decade is to find stocks that will grow earnings much faster than the declining P/E ratio can devalue them. In other words, only stocks with extremely low PEG ratios will make investors money.

Using my trusty Bloomberg terminal, I screened for stocks with high PEG ratios and low PEG ratios.

I also added some financial strength criteria to make sure the high-PEG overvalued stocks were also financially weak and the low-PEG cheap stocks were also financially strong. The stocks with the best PEG:

Gulfport Energy (GPOR)
Brightpoint Education (BPI)
Apple (AAPL)
Crocs (CROX)

Read more from Investing Daily here...

Related Reading:

Fundamentals Point to 7 Dividend Payers

A Comcastic Omen for America

A Pipeline to Bigger Dividend Hikes

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  3. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  4. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  5. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  6. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  7. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  8. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  9. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  10. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>

You May Also Like

Trading Center