In part 1 of my series on demographic investing, I wrote about author Harry Dent and his use of birth rates and lifecycles to determine when aggregate consumer spending is rising and falling. Dent’s theory that consumer spending is a leading economic indicator of stock prices makes intuitive sense, but his performance track record demonstrates an inability to translate economic theory into investment profits.

Some readers took issue with my treatment of Dent’s demographic investing theories, arguing that demographic trends are long term in nature whereas stock-market fluctuations can be influenced by a countless number of short-term and ephemeral factors. I completely agree and let me reemphasize my belief that using demographics in investing makes a lot of sense.

Harry Dent is Not Alone in Using Demographics to Forecast Consumer Spending

Indeed, many investment strategists use demographics to make stock-market forecasts just like Dent does. One example is Toronto-based David Rosenberg of Gluskin Sheff, an economist who keeps track of the 45- to 54-year-old demographic, which is a slightly larger group than Dent’s 46-50 demographic. In August 2010, Rosenberg noted the following:

The 45-54 year old cohort has the lowest savings propensity, the highest earnings level and the greatest increase in net worth compared to other age categories. From 1984 to 2010, this cohort rose each and every year. That didn’t prevent business cycles from occurring or the odd vicious bear market, but over that period, the stock market, in constant dollar terms, advanced 240%. But starting next year, this key age cohort for both the economy and the markets will begin to decline each and every year to 2021.

The last time we saw sustained declines in this part of the population was from 1975-83, which was an awful time for both the economy and the S&P 500 which, in real terms, was as flat as a pancake and real per capita income barely expanded.

Demographics Can Also Forecast Supply and Demand for Stocks

Analyzing birth rates and consumer spending to forecast corporate profits is only one way to use demographic analysis to predict stock prices. Another way is more technical in nature and looks at supply and demand for stocks. For example, in August 2011 the Federal Reserve Bank of San Francisco issued a report on the negative effect the retirement of the baby-boom generation (born 1946 to 1964) will have on the demand for stocks and, consequently, stock prices:

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.

To measure the degree by which the U.S. population is aging and retiring, the authors utilize a metric called the “Middle-/Old-age ratio” which divides the number of people aged 40 to 49 (prime earnings and spending years) by the number of people aged 60 to 69 (retirement age with declining spending). It turns out that between 1954 and 2010 this M/O ratio was highly correlated with the P/E ratio of the stock market – when the M/O ratio rose stock valuations (as measured by P/E ratio) also rose and when the M/O ratio fell stock valuations also fell:

Between 1981 and 2000, as baby boomers reached their peak working and saving ages, the M/O ratio increased from about 0.18 to about 0.74. During the same period, the P/E ratio tripled from about 8 to 24.

In the 2000s, as the baby boom generation started aging and the baby bust generation started to reach prime working and saving ages, the M/O and P/E ratios both declined substantially. 

Declining M/O Ratio is Bad News for Stock Prices Through 2021

According to the SF Fed, the decline in the M/O ratio has just begun and will continue to decline until 2025! The stock market’s P/E ratio will fall in unison from its current 16 times earnings to only 8.3 times earnings, a 48% decline. In other words, in 2025 investors will value a $1 worth of earnings 48% less than it values a $1 worth of earnings today. So, the average stock with earnings per share of $1.00 is valued today at $15, but will be valued at only $8.30 in 2025 if its real (i.e., inflation adjusted) earnings remain the same.

Of course, the U.S. economy typically grows in real terms and so do corporate earnings. The Fed authors expect real earnings to grow 3.42% annually over the next decade. Yet the M/O ratio will decline so much that the resulting reduced P/E ratio will overwhelm the growth in real earnings and cause stock prices (in real terms) to decline by 13% between now and 2021. No wonder some smart investors like PIMCO bond king Bill Gross like bonds more than stocks!

Between 2021 and 2025, the M/O ratio will continue to decline but at a much lower rate so that real earnings growth will be sufficient to allow real stock prices to grow slightly, but no big stock rally will occur until 2025 when the M/O ratio stops declining.

Depressing stuff. On February 10^th investment bank Credit Suisse (NYSE: CS) issued a report on demographics and asset prices that reached a similar conclusion to the earlier SF Fed report. The only difference is that the Credit Suisse analysts are even more pessimistic than the Fed and project the stock market’s P/E ratio to fall even harder into 2025 – down all the way to 5.2 times earnings, which would be a 68% decline (p. 16).

Low PEG Ratios are the Solution

My takeaway from all this gloom is that the only way to make money in the stock market over the next decade is to find stocks that will grow earnings much faster than the declining P/E ratio can devalue them. In other words, only stocks with extremely low PEG ratios will make investors money. Using my trusty Bloomberg terminal, I screened for stocks with high PEG ratios and low PEG ratios.

I also added some financial strength criteria to make sure the high- PEG overvalued stocks were also financially weak and the low-PEG cheap stocks were also financially strong. For those unfamiliar with the Altman-Z score, it measures overall financial strength with readings above 3.0 signaling health and readings below 3.0 signaling an above-average chance of bankruptcy.  Without further ado, the risky and safe stocks are listed below:

High PEG Ratios: Riskier Stocks

Low PEG Ratios: Safer Stocks