This Changing Demographic Could Change the Course of the Stock Market Forever

Baby boomers (the roughly 78 million people who were born between 1945 and 1964) are a powerful cohort. Their presence in the U.S. workforce began to grow quickly in the 1980s and, by the 1990s, there were three middle-aged Americans for every older American. How did this bulge kick in?

Between 1956 and 1964, there were more than 4 million U.S. births annually, a feat that has never been matched since.

The reason: Middle-aged workers are at their peak of career productivity and can help an economy to grow at an above-trend rate without inducing inflationary pressures. More to the point, they are in their peak savings years, and tend to deliver especially robust money flows into the stock market to fund their retirements.

In contrast, older workers tend to play a less productive role in the economy, eventually choosing to retire, at which time their financial positioning changes. "Retirees are disinvesting, in order to buy goods and services that they no longer produce, and they are no longer contributing goods and services into the macro economy. This effect is less pronounced for bonds, presumably as these are sold later in retirement than stocks, conforming to widespread popular financial advice," wrote Robert Arnott and Denis Chaves in a June 2011 paper entitled "Demographic Changes, Financial Markets, and the Economy." But their main conclusion is inescapable: "Large populations of retirees (65+) seem to erode financial markets performance as well as economic growth."

While a number of theories have been put forth about the relative underperformance of Japan's Nikkei index in recent decades, this demographic factor appears to have played the biggest role, according to Arnott and Chaves.

Roughly 23% of all Japanese citizens are now over 65, up from 11.6% in 1989. This figure is set to keep rising. Japan's population is set to shrink from a current 125 million to 95 million by 2050, and a rising percentage of the population will be elderly, according to the Japanese Health Ministry. Here in the United States, roughly 14% of all Americans are over 65, and this percentage is expected to rise to 20% by 2030, according to the U.S. Administration on Aging.

This milestone, which was only reached in 2011, will stay in place until 2030. When the Baby Boom began, there were roughly 15 active workers for every retiree. Now, that ratio has shrunk to just 2-to-1, and is expected to keep dropping. (The slow economy has led some Baby Boomers to forestall retirement, which will slow, but not stop this trend).

Longevity is another factor: The average time between retirement and death for an American male has increased from 13 years to 17.5 years since 1970 -- a 34% jump, according to Amy Kessler, an economist with Prudential Reinsurance. Robert Arnott, the author of the earlier-noted paper on Demographics, told The Wall Street Journal in March 2012 that "in 10 years, there will be 10 new senior citizens for each new working-age citizen."

There is an investing maxim that you should adjust your portfolio over time by subtracting your age from 100 to decide the amount of your net worth exposure to stocks. i.e. a 65-year old should have 35% of assets (outside of homes, bonds, jewelry, etc.) in stocks and by the time one hits 80, that figure should drop to 20%.

As a result, aging Baby Boomers are likely to be net sellers of stocks, and at the end of the day, stock prices are determined by the simple rules of supply and demand.

That's the projected P/E ratio on the S&P 500 in 2025, roughly half of what it is today, according to San Francisco Fed's Liu and Spiegel. They arrive at that figure by extrapolating the declining M/O ratio, which has already fallen from 0.74 to 0.65, and could move below 0.50 by 2025.

A shrinking P/E ratio doesn't mean the market will fall in absolute returns, but returns will lag the rate of inflation, according to these economists.