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Demographics and the Financial Markets

William Hester, CFA
September 2004
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Each summer the Federal Reserve Bank of Kansas City hosts a symposium where the top bankers, academics, and strategists gather to tackle the toughest economic issues of the times. Topics reflect current concerns – last year's discussion focused on monetary policy under uncertainty. Last month's get-together kept this tradition by taking on the topic of global demographic change and its effects on economic policy.

Fed Chairman Greenspan grabbed headlines with his discussion of demographics and the entitlement programs. He said that as a nation we should promise retirees only the benefits that can be delivered, and that we've already promised more than the economy will likely be able to provide.

Beyond the headlines, other topics were addressed. One discussion that is sure to gain in popularity: How will the financial markets react to the expected changes in demographics?

Demographics & Financial Markets

The United States – and most developed countries around the world – is about to get older, fast. Within 30 years the percent of the U.S. population over 65 years of age is projected to double, making that group more than a quarter of society.

Baby boomers account for some of this increase. The rest can be explained by a dramatic increase in life spans. Between 2000 and 2050, the population of 75 to 84 year olds is expected to double and those 85 and over could increase by 300 percent. Centenarians, which hardly existed a generation ago, are projected to grow tenfold during this period.

As this group expands, the working age population will shrink. This can be seen in the ratio of workers to retirees. In 1950, there were 16.5 workers per retiree. In 2000, this ratio fell to 3.4. In 25 years, the ratio is expected to be just 2 workers for each retiree.

What will these demographic changes mean for financial markets?

One popular theory is that stock prices will be marked down as baby boomers find fewer buyers for their savings. In their paper Demographics and Capital Market Returns , money mangers Rob Arnott and Anne Casscells say that “the simple mechanisms of supply and demand should lower the return on assets: A larger group of retirees than ever before will be selling to a proportionately smaller working population than ever before.”

An argument against this ‘asset meltdown' theory was presented at last month's Fed conference. James Poterba, an economics professor at the Massachusetts Institute of Technology, argued that retirees hold onto a majority of their assets in retirement rather then selling them. This calls into question the Doomsday theories about equity returns, he says.

In his paper Population Aging and Financial Markets , Poterba does concede that the 65 to 85 age group will hold a majority of financial assets. Using the Fed's Surveys of Consumer Finances, he estimates that the share of net financial assets (consumer debt minus gross financial assets) held by households over 65 will grow from 31 percent of the total to 37 percent in 2020. By 2040, this group will hold 44 percent of net financial assets.

By comparison, households aged 40-64 – those in the best position to accumulate assets – now hold 58 percent of net financial assets. In 2020 households in that age group will hold 54 percent of the total, and by 2040 only 47.5 percent.

But retirees are actually slow to sell financial assets, says Poterba. The Survey of Consumer Finance data shows that financial assets decline only gradually when households are in their retirement years. The median net worth of Americans between the ages of 70-74 was $133,840 in 2001, compared with $134,140 in the 55-59 age group.

“When these data are used to project asset demands in light of the future age structure of the U.S. population, they do not show a sharp decline in asset demand between 2020 and 2050.”

This result can be explained by the huge stakes held by very wealthy families. According to a recent Survey, the mean net financial wealth of households headed by those in their early 60's is eight times greater than the median household. These families are unlikely to sell large equity stakes to fund their retirement, says Poterba.

Demographics and Demand

The role of demographics and stock market returns will continue to be hotly debated. Another important consideration for the financial markets is the role that an ageing population will play in shifting demand preferences.

Many retirees prefer bocce balls to business suits. They're also active consumers of healthcare services and cruise ships. Can anticipating these trends offer extra return?

Efficient market theorists would say that while trends in demographics are important, they've been known for 30 or 40 years and are already reflected in share prices.

Maybe not, says Stefano DellaVigna and Joshua Pollet, assistant professors at UC Berkeley and Harvard University, respectively. They suggest that investors may not incorporate changes in demographics that occur more than five years out.

To explain the process and results of their research, they provide an example. If a large number of babies were born in a particular year, you might expect the shares of companies who sell busses to rise immediately, to incorporate the increased demand in 10 years. But DellaVigna and Pollett found that investors actually began to incorporate the expected increase in demand within just five years of the children first entering school.

In their paper: Attention, Demographics, and the Stock Market , DellaVigna and Pollet looked at 47 industries over 65 years. Their results were strongest where industries had high barriers to entry, which limit intense competition.

They argue that because analysts don't forecast earnings longer than five years into the future, investors don't incorporate long-term trends such as demographics into their investment decisions.

They point to data provided by I/B/E/S, a firm that tracks earnings estimates (now part of Thomson Financial). Almost all of the companies covered had earnings forecasts for the next two years. But then estimates dropped off. Fewer than half of the companies had forecasts 3 years ahead and fewer than 10 percent of the companies had 5-year forecasts.

“Investors do not possess readily available information regarding profitability in the distant future. Given this evidence, it would not be surprising if investors ignored outcomes more than 5 years in the future.”

The authors say that while ignoring information about the distant future is usually a good strategy (long-term GDP forecasts and consumer taste-changes, for example, are difficult to predict), demographic estimates are unusually stable.

The discussions and debates about the role of demographics on the financial markets are just beginning to simmer. With population trends set for at least the next 75 years, they have plenty of time to come to a boil.


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