The Independent Market Observer

Demographics and Stock Market Valuations

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Aug 21, 2014 1:22:00 PM

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stock market valuationsYesterday, I received a question from Joe Esposito that touches on some very relevant demographic-related issues:

“How do you feel about Harry Dent's prediction of a Dow 5,500 and the next big crash starting within the next 24 months or so? Just curious on your take regarding his demographic viewpoints and positioning with booms and busts. (Highs are higher and busts will be lower than that last.) Thoughts?”

There are two issues here:

  • First, how do demographics affect stock market returns?
  • Second, are we positioned for a crash in the next couple of years?

Good questions both. Thanks, Joe!

How reliable are market forecasts based on demographics?

Harry Dent is a noted market predictor who bases much of his analysis on demographics. Intuitively, and for the reasons I discussed a couple days ago, this makes sense. The economy is people, and demographics is the science of people. The problem is that the connections are both loose and uncertain, so making those predictions is somewhat fraught.

When I’m asked, “What do you think of his predictions?” my response is to ask, “What predictions are those?” For example:

I don’t mean to pick on Mr. Dent here, but given his track record, I would be hesitant to put too much money into his current predictions. His prediction for the 40,000 Dow was based on the very favorable demographic trends he saw in the mid-2000s. You may remember that didn’t work out so well. Forecasting markets based on demographics is tricky.

A major market decline not out of the question

At the same time, it would be a mistake to disregard the message because of the messenger. There are reasons to be concerned about market valuations, as I've noted many times before. Let’s look at what a decline of that magnitude, about 67 percent, would mean. (Rather than the Dow, I’ll use the S&P 500 for the discussion, as the data is easier to put together.)

From the S&P’s current level (1,992 as I write this), an equivalent decline would take us down to around 645. This is somewhat below the minimum level of 666 reached in the great financial crisis, so there is certainly historical precedent. It could happen.

I will discuss the likelihood of it happening tomorrow, but today let’s focus on what it would mean if it did.

For investors, opportunity; for retirees, disaster

First of all, using current earnings, such a decline would be an outstanding buying opportunity. At 645, the price-to-earnings ratio would be about 6.4—amazingly cheap. Put another way, the earnings yield (the amount of money that companies make each year as a percentage of the stock price) would be over 15 percent, the highest level since the late 1940s, or before that, 1917.

What would that mean for investors? At current valuations, history shows that forward returns, over the next 5 to 10 years, are typically in the low single digits—maybe 4 percent to 5 percent per year. At the lower value of 645, forward returns have historically been in the range of around 15 percent.

For those now investing in the market, any such decline would be a major buying opportunity, a chance to get an extra 10 percent per year on average on their investments. For anyone now retired, or close to it, it would be a disaster, pretty much blowing up retirement plans in most portfolios.

Clearly, the risk is what we have to focus on here. Opportunities are nice, but risks are for real. Tomorrow, I’ll take a look at just how likely such a crash seems to be, and discuss ways investors can potentially both protect themselves and even try to benefit from such an event.

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