Demographics and Stock Market Valuations

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

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

and tagged Investing

Leave a comment

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.

Upcoming Appearances

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®