Wednesday, October 17, 2012

Expect A Lousy Stock Market This Decade

A new Federal Reserve study predicts that investors are in for a bear market in stock market valuations lasting another decade or more in part due to aging of the US population.  Notice I say a bear market in valuations.

The market is currently back to levels first seen in 1999, meaning that we've already been in a flat to declining market for 13 years now.   Even though the market is flat, the Price-to-Earnings (PE) ratio of the S&P 500 has come down by about 50% from it's peak valuation in 1999.  Note also that duration shown for average bear markets is about 18 years.   So, five more years of bear market can be expected as implied from history.

Have a look at the following graph from Sitka Capital Management showing the market's declining PEs and projecting a further PE decline if it were an average bear market.   We may see another 20% PE decline. With a lot of volatility, the market price will probably remain flat (the P in PE) to down in the years ahead.

Figure 6 Bear Market Valuation Contractions-Past and Present (http://www.sitkapacific.com/files/Sitka_Pacific_Capital_Management_June_2012_Client_Letter.pdf)
Demographics Are Now Very Unfavorable For America
Harry Dent, the famous Harvard-trained demographer, predicted in the early 1990s that, on or around 2012,  the aging of the baby boomers will cause the US economy to stagnate.  That remains his seminal forecasting achievement.

His research shows that, on average, people's personal spending peaks at about the age of 46 to 50 years old and declines thereafter.  It makes sense to me (I'm 55 years old).  After all, after the late 40s, children generally have graduated from school, have left the 'nest' and couples are starting to save in earnest for retirement---even downsizing their lifestyle and housing.   Demand for housing, furnishings, gasoline, retail items and many other things do indeed decline as you get older.

The peak of baby boomer population bulge has now passed this 46 to 50 age bracket as of 2011.  And sure enough the economy remains in the proverbial "crapper."   No one seems to understand why the recovery remains stalled even with $1+ Trillion dollar government deficit spending, zero interest rates and easy money ad infitum.  Harry Dent would reply that it's demographics (as well as the post-bubble debt overhang).

He's also long concluded that the stock market could easily fall 50% due to poor economic and profit conditions in a bear market caused by poor demographics.   Well, we already had our 50% decline in 2009! But it's recovered since.

The Federal Reserve Study Shows That Stock Market PEs Will Stay Depressed
The Sitka Capital report is not the only study predicting that the market valuation is heading lower.  None other than the Federal Reserve Bank of San Francisco agrees.

The Federal Reserve Bank of San Francisco has also published research that shows that the Stock Market will likely remain in a slump for years, even decades ahead.   They have shown that the ratio of older people (aged 60 to 69 years old) to middle (aged 40 to 49 old) people, called the M/O ratio,  is directly correlated to stock market Price-to-Earning ratios (PEs).  They figure that it explains about 60% of the movement of stock prices.  It's another way of saying that this study agrees with Harry Dent's demographic explanation.
See Figure 3 and 4 below.
Figure 3 Stock Market PE versus M/O  Shows the correlation between Stock Market PE and a ratio of middle aged population to older aged population (M/O).   

Figure 4 Projected Stock Market Price to Earnings (PE) Ratio.  Based on Projected M/O from demographics, it is possible to project Stock Market PEs based on correlations established in Figure 4.
According to their projections, you can expect the market's PE to decline and market prices to remain depressed through the current decade until 2017 or longer.  The good news:  Figure 1 and Figure 4 show the majority of the PE decline is over.   If the PE of the market declines further, this may mean that stock market prices may remain steady as earnings go up.    It also may mean that stock prices decline significantly.

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