Aging population – market time bomb?

Okay, that’s a sensationalistic way to put it, but that’s certainly one of the fears people have about an the shifting demographics in North America. Last time around I looked at how portfolio size tends to trend lower as people go past 65. All things being equal, the older the population gets, the more money that is going to be pulled out of the market. Question is, at what point does the ‘market time bomb’ thing go from sensationalism to reality – or does it?

Today, let’s look at a nifty demographic ratio that is useful in predicting the direction of the markets – the “Middle Young Ratio”.

The Middle Young Ratio is pretty much what it sounds like – the ratio of 40somethings in an economy to the number of 20somethings. Why that ratio? Well, 40somethings are the savers. They see the end of their working lives looming, and they are anxious to squirrel something away for retirement. All thing being equal, they also are in a better place to save than younger people, presumably having made a dent on their mortgages and all that.

For 20somethings, the world is a different place, a place full of things to buy.  Incomes are lower anyway, and the focus is on paying down debt rather than saving for retirement (which is so far off it seems ludicrous to think about).

It you take the ratio of the two ‘cohorts’ (fortysomethings and twentysomethings) you get an idea of how the balance in the economy is running. This ratio is the middle young ratio (sometimes called the “Medium Young Ratio”) or simply the MY Ratio. [1] (As a side note, in 2009 an analyst at Mirae Asset Fianncial Group nicknamed the MY Ratio the ‘Demi-Ashton Ratio’ after Demi Moore and Ashton Kutcher. It was cute, and he got to do a lot of media on it, but not actually that lasting a moniker, since Demi will be 50 by 2012, and Ashton was actually already 32 by the time his analysis came out).

Then again, as interesting as all that might be, can it really help you figure out what is going on in the financial markets?

Well, at least in a backward-looking sense, there is a pretty strong correlation.  Here, according to my calculations, is how the ratio has looked for the U.S. the past few years (I used mid-year Census Bureau estimates for the U.S. civilian population to calculate the 20something and 40somethings, and the PE Ratio is for the S & P 500 at year end).

The correlation is a bit crude, but you get the idea: from the mid-1980s through to the beginning of the 2000s were the years destined to be the best for stocks, or at least for PE Ratios. Why not? Lots of money was being thrown at them (some of it indiscriminately, as it happens). So sure, valuations got shoved higher, all things being equal.

Although there has been plenty of this kind of analysis done in the U.S., to my knowledge no one has really looked at it for Canada, so I ran those numbers too, using the year-end P/E ratios on the TSX.

This time the correlation wasn`t as clear, thanks to the fact that the P/E ratios were all over the place  (in fact I excluded a few outliers that would just confuse all of us). That volatility is thanks to the commodity stocks which proliferate on the TSX, and which can have valuations that fluctuate wildly.  A better way to use the MY ratio in Canada would probably be to try a correlation that excludes commodities.

All very interesting  stuff…but does it tell you what will go on going forward? Can you actually use this to predict the direction of the markets?

 Next: Using the MY Ratio to Predict the Direction of the Markets (more or less)

[1] To see the original discussion of and reference to the MY Ratio, see “Demography and the Long Run Predictability of the Stock Market“ (2004) by John Geanakopolus, Michael Magill and Martine Quinzii, Cowles Foundation Discussion Paper.