Size Matters (More)

size mattersMy recent post on the small-cap premium and my tentative hypothesis that sub-linear scaling in companies helps to explain it has received a substantial amount of interest — privately, publicly, and even a bit in the comments. Due to the remarkable response, I wanted to add a few clarifying points.

  1. I don’t suggest that the sub-linear scaling Geoffrey West discovered within companies fully explains the small-cap premium.  There are a number of factors at work (including risk, the standard explanation for the small-cap premium), and these can cut in a variety of ways.
  2. Most of the criticism centers upon the (very tentative) conclusion rather than the data.  If the data is accurate — and I see no reason to doubt it to this point — it suggests that smaller companies, once they have reached something like critical mass, are decidedly more efficient than larger companies.  That added efficiency, if and when fully verified, would indeed support both the existence and the persistence of a small-cap premium.  Those who disagree with the (again — very tentative) conclusion must still account for the data.  To this point, none of the critics has even made an attempt to do so.
  3. Further discussion and (especially) further research will be necessary to see if this idea holds up.  I emphasize that it remains merely a hypothesis to this point. It seems consistent with and supported by the data but remains in need of verification.

As always, comments and criticisms remain welcome.


The Missing Lead

big_butt_chairI’m a big fan of Jake Tapper.  I thought he was terrific at ABC News as the senior White House correspondent and I was disappointed when he wasn’t picked to host This Week both when George Stephanopoulos left in 2010 and when he came back in 2012.  As of 2013, Jake returned to CNN to become Chief Washington Correspondent and anchor of a new weekday television news show, The Lead with Jake TapperThe Lead, which debuted this week to generally good reviews, is the first CNN show to launch since Jeff Zucker took over as president of CNN Worldwide to revitalize the franchise.

I agree with the good reviews, but there’s a “big but” coming. Continue reading

The Price of Safety

The Price of SafetyThe Fed has been using all the tools at its disposal to try to encourage (some would say “force”) equity investment and, by all appearances, has succeeded rather spectacularly.  As Josh Brown pointed out Saturday, the current cyclical rally has now exceeded four years.  Indeed, according to Bespoke Investment Group, the rally has reached 1,460 days, making it the eighth longest of all time and causing to some to question whether we may have entered into a new secular bull market.  Stocks have more than doubled over that period.  Those who have avoided stocks — likely seeking “safety” — have been crushed no less than whose who held on through the March 2009 lows. Continue reading

Pay No Attention to that Man Behind the Curtain


Josh Brown’s terrific book, Backstage Wall Street, does an excellent job illuminating what Wall Street wants to hide from clients and investors.  Like the Wizard in The Wizard of Oz, the Street would have us pay no attention what is really there — “behind the curtain.”  Yet once in a great while the Street rats itself out so that we get to find out, without a shadow of doubt (if you still had any), what the big investment houses really think about what they do and who they do it to.

It isn’t pretty.  

The now-defunct Bear Stearns won a noteworthy 2002 litigation involving former Fed Governor and then-Bear Chief Economist Wayne Angell over advice he and the firm gave to a Bear Stearns client named Count Henryk de Kwiatowski (really) after the Count lost hundreds of millions of dollars (really) following that advice (back story here). The jury awarded a huge verdict to the Count but the appellate court reversed. That Court decided that brokers may not be held liable for honest opinions that turn out to be wrong when providing advice on non-discretionary accounts.

But I’m not primarily interested in the main story. Instead, I’m struck by a line of testimony offered at trial by then-Bear CEO Jimmy Cayne . Cayne apparently thought that Bear could be in trouble so he took a creative and disarmingly honest position given how aggressive Bear was in promoting Angell’s alleged expertise. Cayne brazenly asserted that Angell was merely an “entertainer” whose advice should never give rise to liability.

Economists are right only 35% to 40% of the time, Cayne testified . “They don’t really have a good record as far as predicting the future,” he said. “I think that it is entertainment, but he probably doesn’t think it is” (and I doubt that the Count was much amused).

Cayne even noted that Angell did not have a real job description at Bear. “I don’t know how he spends most of his time,” testified Cayne . “He travels a lot and visits people and has lunches and dinners and he is an entertainer.”

Notice that Cayne did not even pay lip service to the idea that clients were entitled to the firm’s best efforts based upon the best research (or even their best research).  Moreover, he did not seem to think that the Count deserved honesty together with competent advice.  For Cayne, the goal was simply to be entertaining and to make sales. That the Count lost hundreds of millions of dollars was merely collateral damage (and not even necessarily unfortunate at that).

To look at the Count’s case a bit differently, in an odd sense, Cayne was precisely if hypocritically correct. As both Josh and I have noted before, we’re in the Wall Street “silly season” of predictions and forecasts for the New Year. There is nothing inherently wrong with them, and they can be very entertaining indeed. But you shouldn’t take them any more seriously than Jimmy Cayne did.

And you should always be aware of who has (and especially who doesn’t have) your best interest in mind – practically, realistically and legally.

Doubling Down on Disaster

In early 2000 I was at a big pitch extravaganza for the soon to launch Merrill Lynch Focus Twenty fund.  Mother had snapped up star manager Jim McCall from PBHG to start and run the fund which was designed to hold McCall’s 20 best ideas.  These were, ubiquitous for the times, all very aggressive growth (and mostly tech) firms, even though the terms of the fund allowed him to invest virtually anywhere.  The “focus” idea was to avoid diversification so investors could really make money when the “best ideas” popped, since the fund was to be aggressively traded too. At PBHG, McCall managed its Large Cap 20 fund. In the two and a half years Mr. McCall ran it, that fund raked in average annual returns in excess of 50 percent.

McCall had to wait more than a year to start at Merrill due to a contentious departure from PBHG and the resulting litigation.  He had been a successful stock picker and Mother paid a fortune (undisclosed) to win his services. At the time, Merrill was known primarily was a value shop, but McCall was upfront about his lack of interest in valuations or profitability.  His focus (so to speak) was the “new economy” — a good story with earnings and growth momentum, albeit from a tiny base.  ”Valuation is not one of the factors that enters into our methodology,” McCall said repeatedly.Dead Bull

At the pitch, we were told to get in while the getting was good.  Tech was hot and there was lots of money to be made.  Risk?  What risk?  We were pitched hard.

The fund launch was a huge success, with initial assets in excess of $1 billion and an initial share price of nearly $9.  And, back then, $1 billion was real money.  Assets later exceeded $1.5 billion and the price peaked above $10. 

I didn’t buy the fund for myself and I didn’t sell any of it either.  At lot of people thought I was nuts but things turned out all right for me if not for McCall.

The Focus Twenty launch came at the height of the tech bubble and of the hubris that characterized that time.  But barely a year later, Focus Twenty had the ignominious distinction of ranking in the bottom 1 percent among funds of its kind for the previous day, week, month, quarter and year and was down roughly 80 percent.  McCall refused to capitulate and kept doubling down on his strategy, all the way to the bottom.  Before 2001 ended, McCall was gone and has barely been heard from since.

As Morningstar said at the time, “McCall’s short tenure at Merrill has been an unqualified disaster.”

The easy lesson to draw from the Focus Twenty debacle is the importance of diversification. But what sort of diversification?  Market diversification protects against idiosyncratic risk.  But without idiosyncratic risk, you might as well hold index funds.   

By definition, active managers have clear points of view with respect to what is rich and what is cheap.  Concentration (pardon the pun) on selling what is richest and buying what is cheapest is how active managers go about trying to beat “the market” (and it is usually an index that benchmarks whether they have done so).  Diversification in that sense means that an active manager is in reality a “closet indexer” and, on account of lower fees, they will find it essentially impossible to beat the market long-term. Active managers want concentration rather than diversification.

However, even the best and most successful active investors make mistakes and have down periods – which can last significant periods of time.  This problem is particularly acute during secular bear markets which last, on average, about 17 years. The current one began in 2000, just after the launch of Focus Twenty. During these secular bear markets, equity markets are prone to strong cyclical swings in both directions.  In 1977, during a previous secular bear market, Time magazine called this phenomenon a “roller-coaster to nowhere.”

So if you are committed to active management, which favors concentration, how do you avoid disasters like McCall’s?  The best way for most individual investors is probably to maintain concentration within investment vehicles while owning such vehicles in at least several market sectors.  That said, for individuals and professionals alike, the active management investment process needs to be a very good one to succeed.  What’s hot can remain so for an agonizingly long time even though the strategy is anything but a long-term winner.  Growth investing worked for a long time during the tech bubble, but valuations matter longer-term.  Some approaches and factors have stood the test of time for making investment decisions — such as value, size and momentum.  Make sure your activist approach can be supported by the data.

Finally, it is crucial to remember that what’s true in investing today may not be true tomorrow.  We must not be capricious and must insist on a careful and data-driven orientation.  But we also need to be open to new and better evidence. 

As Tadas Viskanta so often says, investing is hard.  There are no guarantees.  Just ask Jim McCall.

Hot Action Item

Five years ago my family and I were awakened early in the morning and forced to evacuate our home due to raging wildfires burning out of control near our home in Southern California and fanned by winds gusting to over 100 miles per hour (as shown right).  Unlike many of our neighbors, we had time to gather a few things before we escaped.  We left seriously doubting that we would return to find our home still standing.

After nearly a week we were allowed back into our neighborhood.  Fortunately, our home survived.  We suffered smoke damage and some damage to trees, but few other problems of note.  Many of our friends and neighbors were not nearly so lucky (see below). Just within our church community, 70 families lost their homes.  We live with “fire season” every year.  But the problems and the risks have grown consistently over the 17 years we have lived in San Diego and they will continue to grow, largely on account of climate change.

According to nearly all working scientists in the field and the various organizations representing America’s best scientists, climate change is a fact. It is very likely caused by the emission of greenhouse gases from human activities and poses significant risks for a range of human and natural systems. As these emissions continue to increase, further change and greater risks will ensue.  These risks include rising temperatures, extreme weather, and the problems caused or (more typically) exacerbated by them.  A helpful summary of the science of climate change is provided by the following video.

Without belaboring what is remarkably clear, temperatures are rising significantly.

Source: NASA

And sea level is rising and rising faster.

Source: NASA

With events like Hurricane Sandy crashing onto the East Coast recently becoming more and more common, it is exceedingly difficult to ignore the increased and intensifying storms, droughts, cold snaps, heat waves, wildfires and disease that inevitably follow from climate change and which are causing devastating damage and disaster-related losses, according to organizations like the National Oceanic and Atmospheric Administration and the Intergovernmental Panel on Climate Change.  It also means more agriculture-related problems and more variability in weather patterns.

If you don’t want to believe scientists directly, then believe the highly profit-motivated insurance industry, which has become the first major business sector to acknowledge the effects of climate change and to seek to deal with that risk in a systematic fashion.  Just two weeks before Sandy slammed onto the Jersey shore, German reinsurance giant Munich Re issued a report entitled Severe Weather in North America, in which it linked the risks of severe weather events to human-caused, or anthropogenic, climate change:  “In the long-term, anthropogenic climate change is believed to be a significant loss driver. […] It particularly affects formation of heatwaves, droughts, thunderstorms and — in the long run — tropical cyclone intensity.” Allianz actively lobbies for worldwide, binding carbon emission targets and has designed various insurance products to deal with climate change risk, such as catastrophe bonds and micro-insurance. Swiss Re also has a product line that is explicitly geared toward climate-change risks.

Or perhaps you’ll be influenced by the United States Navy, which is actively preparing for an ice-free Arctic Ocean.  Indeed, a major study commissioned by the Pentagon asserts that climate change is a greater threat to national security than terrorism. Even oil companies (see here, for example) acknowledge the facts of climate change and its human causes.

There is a dedicated group of climate change “skeptics” who insist either that climate change is a myth or that its risks are overstated.  Since causation is such a difficult matter to ascertain to everyone’s satisfaction (and especially to the asserted satisfaction of those whose financial status is threatened by climate change), there will be some kind of debate about this for the foreseeable future.  But no serious climate scientist believes that sea level will rise less than a meter this century unless we get off fossil fuels with great haste.  Many forecasts are much grimmer.  At least 20 port cities will be seriously exposed to coastal flooding risks in the coming decades including Mumbai, Calcutta, Ho Chi Minh City, Shanghai, Bangkok, Tokyo, Miami, Alexandria, and New York (as Hurricane Sandy demonstrated).

But even if the science were in dispute, when an activity raises threats of harm to human health or the environment, precautionary measures should be taken even if some cause and effect relationships are not fully established. In this context the proponent of a threatening activity, rather than the public, should bear the burden of persuasion.  If they cannot do so — by establishing that climate change is not a substantive risk — then we should act as if climate change is a major risk to our lives and health. This approach is particularly appropriate, as Nassim Taleb points out, because the extent of the threat and the risks are so high.  As Taleb explains, we should readily use a headache pill if it is deemed effective at a 95 percent confidence level but assiduously avoid such a pill if it is established that it is “not lethal” at a 95 percent confidence level.

The results of the presidential election and the impact of Hurricane Sandy suggest that there might finally be some traction toward dealing with climate change.  After a campaign devoid of its consideration, climate change was finally brought up by New York City Mayor Michael Bloomberg in his surprising last-minute endorsement of President Obama in the wake of Sandy. The President himself returned the issue to public light by speaking of it in his acceptance speech on election night:

“We want our children to live in an America that isn’t burdened by debt, that isn’t weakened by inequality, that isn’t threatened by the destructive power of a warming planet.”

Yet, to this point, little has been done.  Neither New York City nor New Jersey, which took the brunt of Hurricane Sandy’s force, have made climate change response a serious priority, perhaps because doing so would create further tax burdens on a population already economically stretched.  More cynically, while storm mitigation is largely a state and local expense, disaster clean-up garners major federal dollars.  Irrespective of the reasons, much needs to be done and almost nothing has been done.

But is there an investment play here?

The reality of climate change doesn’t mean that there’s a trade to be made. Jeremy Grantham (see here) addresses the issue directly: Global warming will be the most important investment issue for the foreseeable future. But how to make money around this issue in the next few years is not yet clear to me.”  I hesitate to disagree with Grantham because of the great respect I have for him, but disagree I do.

With the possible exception of the inverting demographic pyramid, I expect climate change to be the dominant investment challenge and opportunity of our time. But I don’t expect it to play out quickly. For most traders, an actionable item is one that can and should be undertaken right now and is expected to pay off essentially right away (not that there’s anything wrong with that).  But no matter how often I point out that lunch tomorrow is not a long-range plan, I don’t seem to get heard all that often on this point.  Yet I will not be deterred.  Today I offer an action item that will almost surely pay off in the longer term for those with the necessary patience based upon any reasonable interpretation of the available data.  The climate is changing and those changes will have to be dealt with sooner or later.

The denialists do not trouble me in the least.  As Bruce Chadwick puts it, “if your investment horizon is long enough and your position sizing is appropriate, you simply don’t argue with idiocy, you bet against it.”

Investment opportunities in this area fall into two general categories.  Climate mitigation focuses on reducing greenhouse gas emissions while climate change adaptation refers to actions taken to address the risks and opportunities associated with the physical effects of climate change such as changes to temperature, rainfall and ecosystems.

I remain unconvinced about the investment opportunities available with respect to mitigation. Since entrenched energy interests have a strong economic incentive to delay governmental initiatives towards climate mitigation, since climate denialists are likely to oppose such initiatives, and since it remains decidedly unclear which approaches will succeed (even assuming the “correct” approach(es) currently exist), Grantham’s uncertainty is well placed in this regard.  From an investment perspective, we can avoid arguing about the causes of climate change — which are fraught with political peril despite science that is clear — and simply put our money to work in companies that deal with the consequences of climate change while avoiding those entities and regions with the most to lose.

Thus the better investment opportunities exist in climate change adaptation.  Adaptation efforts include improved infrastructure design (Sandy clearly demonstrated the fragility of our energy infrastructure), more sustainable management of water and other natural resources, modified agricultural practices, and improved emergency responses to storms, floods, fires and heat waves.  Infrastructural improvements include sea-walls, dykes, tidal barriers, and detached breakwaters. But since these improvements may have unintended and damaging side effects, for example by displacing erosion and sedimentation, we might also consider “softer” accommodation options that involve restoring dunes or creating or restoring coastal wetlands, or continuing with indigenous approaches such as afforestation.

Other accommodation options include warning systems for extreme weather events as well as longer-term measures such as improving drainage systems by increasing pump capacity or using wider pipes. Of particular interest ought to be food technologies that are resistant to heat, drought and flooding.  Water needs provide opportunities in adaptation strategies for water conservation, storm water control and capture, resilience to water quality degradation, preparation for extreme weather events and diversification of water supply options.

Harsher and more wide-spread droughts will lead to a strain on communities and farmers that need fresh water. At the same time, rising sea levels will affect coastal regions, potentially leading to an increase of salt in ground water. So-called desalination technology has been a non-starter to this point; venture capitalists may want to re-think that. Other water recycling approaches are also promising. Further opportunities exist with respect to innovations in dealing with infectious diseases and pest control, weather forecasting technologies and more efficient irrigation systems.

Because the facts (and the science) are inexorable, society is going to have to adapt to higher temperatures and a rising sea level.  Obviously, it’s much cheaper to deal with climate change before a crisis hits than after a city has been flooded. But there is no reason to believe or expect that we will have the public policy sense to do so.  Moreover, green-energy technologies are still too speculative for the type of call I’m making here. The obvious investment priority is in adaptation technologies that will prepare and help us to deal with effects of climate change.

It is a highly speculative play.  It is a very long-term play.  But it is the right play.  Our atmosphere is getting warmer and that has inevitable consequences.  It is the most important hot action item of our time.

“Just ‘P’”

I’m going to “talk shop” with and for industry professionals today.  Other readers might enjoy the story, though.

In the institutional fixed income world that nurtured me in this business (so to speak), one great internal divide within the major investment banking firms was between traders – those who took positions on behalf of the firm and allocated the firm’s capital – and sales people – those who marketed the firm’s positions.  I was in the sales camp.  You can get a feel for this world by reading Michael Lewis’s terrific first book, Liar’s Poker.  Michael was also a sales guy.

To say that there was often tension between these two groups is to understate what went on.  A lot.

One summer afternoon, shortly after lunch, the market had gone quiet and some relatively good-natured smack was being talked between sales and trading.  Nothing unusual about that.  But there was always an edge to it, of course.

A trader was – yet again – mocking a sales guy on account of the inordinate focus and attention the sales guy gave to his perfectly coiffed hair.  On a trading floor where the best suits were de rigueur, where ties deemed insufficiently stylish (and expensive) could be cut off and hung from the ceiling, and where two shoeshine guys worked full-time, all day, every day, to keep shoes in pristine condition, standing out for one’s grooming habits was quite an accomplishment.  But this sales guy had clearly earned it.

Anyway, the trader was claiming that the sales guy cared way too much about his hair.  By any objective measure, the trader had an excellent point.  As usually happened, the discussion took on a trading connotation.  When the sales guy denied that his hair was any big deal (obviously false), the trader called him on it and noted that his hair-loving was such that no bid would get him to part with it.

The sales guy, feigning indifference but not very well, insisted that it was all no big deal.  Being very good at his job, the trader sensed that blood was in the water.

“I’ll give you a hundred bucks to shave your head.”

Sales people aren’t well known for thinking three moves ahead, but at this point the poor sales guy began to sense that he was in trouble.  He tried to shake it off entirely, saying in an attempt at dismissiveness, “It’s going to need to be real money if you want me to go through the trouble of doing that.”

The trader knew his win was inevitable at this point.  The only question was how things would play out.  So the trader leaned in for the kill.

“How much is real money?”

By this point, the trading floor – a ginormous room with a ceiling two stories up, holding hundreds of people and tons of equipment – was silent and hanging on every word and every nuance of this transaction.

Meanwhile, the sales guy looked like the prey in videos like this one, with the trader playing the tiger.

Desperately trying to look nonchalant (and failing miserably), the prey announced, “I dunno.  Maybe ten grand.”

The trader paused ever so slightly and a grin hinted around at the edges of his mouth.  “You’re done,” the trader replied, using trading language with unmistakable intent and meaning.  In the same way that “You’re done” establishes a binding trade, from which there is no escape, the trader had made it impossible for our hair-lover to undo the damage he had inflicted upon himself.  All the remained was settlement.

Surprisingly, the sales guy tried to weasel:  “If I’m going to shave my head, I’m going to need to see that ten grand, in cash.”

“No problem,” replied the victor, as he got up and left the floor in complete silence – the kind of hush only heard in moments like the last few seconds before the release of the NFP numbers on the first Friday of every month — his footfalls purposefully but quietly crossing the carpeted floor.

He wasn’t gone long. 

In the meantime, the sales guy tried to appear like there was nothing to be concerned about.  He failed utterly.

In short order, the trader strode back onto the floor confidently.  The young woman sitting next to me leaned toward me and noted that, “For ten grand, I’d shave every hair on my body.”

The trader walked over to the sales guy and silently placed a large stack of crisp new bills on the desk and returned to his own seat, smirking triumphantly.

The sales guy quickly got up and left the floor, followed shortly by his boss.  I learned later that the next move was carefully orchestrated so to try to save face.  The boss was insistent that getting “a Kojak” would be unprofessional, particularly to settle a bet with a trader.   So the sales guy caught a cab to midtown and paid a Broadway make-up artist to provide him with a professional skull-cap. 

A couple of hours later he returned to the trading floor sporting the new look while pretending that it had been a joke all along.  But none of us were fooled.  The trader had established his clear superiority within the ethos of the floor.  He kept his pile of cash and won in every way that mattered.

Such tension (and even conflict) between sales and trading was common.

Traders wanted to move their product at levels that were as profitable to the firm (and to themselves, since their pay depended upon their profitability) as possible.  We salespeople were charged with managing relationships with the firm’s clients.  Thus we had a major interest, at a minimum, in seeing the clients’ side of things.  We wanted them to buy and to keep buying. A client who perceives that s/he was hosed or taken advantage of on a trade is less likely to do more business in the future.

We liked to think that we had a longer-term perspective because we looked beyond the current trade.  And to an extent, that was true.  But our role was different from the traders’ and the pressures were different.

When negotiating with a trader over a prospective trade – which usually involved the sales person trying to get a better price for the client – the trader would often ask (in a disparaging and rhetorical way), Who do you work for?” Any concession gained for the client impacted the trader’s (and the firm’s) bottom line directly.  And since traders were paid based upon how well they did, the question brought the sales person’s quandary into sharp relief.  We could be fired if we didn’t sell enough and traders’ low evaluations would hurt too, but we wanted and needed long-term profitable relationships with clients.

The trader in the story above was a friend of mine and was a pretty thoughtful guy overall, especially away from the trading floor.  As he pointed out to me over a beer after work one day, a trader has to deal with his or her (but it was almost invariably his) “P&L” every trade, every day.  On the other hand, as a sales guy, I only had to deal with the “P.”  If a trade lost money or didn’t earn what it could or should have, the trader felt the pain directly.  As a sales guy, I benefitted in some manner from every trade, even if it wasn’t a good one for the firm.

Money managers face similar issues with clients.  They generally see their role as being to beat their benchmark (or, as a practical matter, to stay near their benchmark since that is what they typically need to do for their assets to remain “sticky,” as that’s the primary goal).  Clients feel the sting of the “L” part of “P&L” much more acutely because losses are real to them, even if/when the benchmark is beaten and the losses are less than someone else’s.

“Beating the index” is great and matters a lot when we’re “talking shop” among ourselves.  But it’s small consolation when the “L” is real and being suffered by real people.  Those of us in the business would be wise to remember that.

Worth Reading

I commend some recent articles to your attention.

A Chart is Worth a Thousand Words


Source:  Political Calculations

Per PC, the current national debt burden per U.S. household is roughly $131,113. Over the last four years, that’s up by $49,129 per U.S. household from the $81,984 per U.S. household figure set in 2008. It should be obvious, but note that these numbers are pre-QE3.

Demography as Destiny

Josh Brown had an interesting post yesterday based upon a report from Tobias Levkovich of Citi (Bloomberg story here) focusing on the anticipated boom in 35- to 39-year-olds — those in their key “savings years.” This age group is said to be poised to increase for the next 17 years. Saving and investing by these echo boomers “would generate a new set of equity fund inflows,” Levkovich claims. Levkovich expects the S&P 500 to rise to 1,615 in 2013, about 50 points higher than the index’s October 2007 record and about 12 percent above current levels. Besides demographics, he argues that expansion in U.S. manufacturing, energy, mobile technology and housing and efforts to curb federal budget deficits will combine to drive stocks higher.  He also sees valuations as attractive.

Obviously, Levkovich is generally paid to be bullish, so his forecast needs to be considered in that light.  But still, I hope he’s right.  However, I’m not sold on the growing strength of the economy, anything other than ongoing governmental dysfunction (see here and here, for example) or attractive valuations — even though I could easily be wrong.  I’m also skeptical of his view of the demographics.

The ongoing demography as destiny argument is a fascinating one. A useful paper called Demography and the Long-Run Predictability of the Stock Market back in 2002 argued that P/E ratios are correlated to the ratio of middle-aged people to young adults (the “MY ratio”). When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.  This study claimed that we should see a continued fall in P/E ratios from then (2002) through and until a long-term bottom in stock prices forming about 2018.  So by that measure, Levkovich is about five years early.  It may be hard to imagine a Wall Street analyst being too bullish too soon, but there you go.

On the other hand, a report on Boomer retirement and demand for stocks by researchers from the Federal Reserve Bank of San Francisco got a fair amount of play about a year ago and came to a different conclusion. The full report is available here. They see a strong relationship between the age distribution of the U.S. population and stock market performance too. But they see the aging of the baby boom generation as the key demographic. As Boomers reach retirement age, they are seen as likely to shift from buying stocks to selling their equity holdings to finance retirement. They report that their statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades. 

A helpful discussion of the methodological differences between the papers cited above by Cam Hui is available here.  Hui’s analysis also carefully notes that the differences between the respective findings are not all that great.  The San Francisco Fed researchers concluded that stock prices will bottom in 2021, instead of 2018 as implied by the other paper cited above.   That’s not much more than a rounding error for this types of analysis.

On the other hand (although, like Tevye in Fiddler on the Roof, there is no other hand), a Congressional Budget Office background paper published in 2009 comes to a different conclusion from that offered by the San Francisco Fed researchers.   The CBO paper argues that Boomers won’t sell assets very rapidly to finance retirement on account of several factors.

  1. Boomers will be careful — they are concerned that they might live longer than expected or might face higher than anticipated medical costs.
  2. Boomers desire to transfer assets to the next generation, which should also blunt asset sales.
  3. Since the wealthiest one percent of Americans own about one-third of the nation’s financial assets and, for the most part, the very wealthy don’t sell assets to finance retirement, this asset concentration will help to keep demand steady.
  4. Many Boomers may work longer than they otherwise would have due to losses of retirement assets due to the 2008-09 financial crisis (but the empirical evidence on this point is inconclusive and the impact might be small).

Wharton’s Jeremy Siegel, author of Stocks for the Long Run, says (unsurprisingly) that growth in developing countries should generate enough demand to absorb a baby-boomer selloff and “keep stock prices high.”

The CBO conclusion may be the key one in this context.

Although the retirement of the baby boomers is not likely to cause a large decline in aggregate demand for assets, several economic studies suggest that the retirement and aging of baby boomers could cause a temporary decrease in asset prices. … Empirical evidence, however, has not revealed much connection between demographic trends and the changes observed in financial markets.

Demographics surely matter. Correlations are important (even if distinctly different from causation). But so do lots of other things — like (duh) the strength of the economy or lack thereof and market valuations.  The market did not tank in 2000 on account of demographics and demographics isn’t controlling the nature and extent of this secular bear market even if and as it is a noteworthy factor.  Demographic trends are interesting, useful and important for the markets.  But there is no evidence that demographics is destiny.