In part 1 of my February 2012 series on demographic investing, I discussed Harry Dent’s bearish prediction that the stock market would decline by more than 50% into 2014 because of worsening demographic trends. Specifically, Dent believes that the stock market rises and falls with consumer spending (70% of the U.S. economy). A person’s peak spending years are between the ages of 46-50 when they spent enough time in the workforce to accumulate wealth and are responsible for teenage children who haven’t left for college yet. Since the number of “baby boomers” (born between 1946 and 1964) in the 46-50 age bracket peaked in late 2011 and won’t trough until 2019 at the earliest, Dent foresees a protracted period of sluggish economic growth and consequently a weak stock market.

In part 2 of demographic investing, I discussed a 2011 report from the Federal Reserve Bank of San Francisco predicting lower stock valuations because 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) is projected to fall until 2025. This demographic shift will cause P/E multiples on stocks to fall 48% for supply/demand reasons – old retirees sell stocks to pay for living expenses while middle-age working people buy stocks as investments with excess cash flow from their peak salaries. Selling pressure will overwhelm buying pressure because there will be more old people selling stocks than middle age people buying stocks.

When you combine lower corporate profits resulting from Harry Dent’s projected lower consumer spending (the “E”) with the lower valuations resulting from the Federal Reserve’s projected worsening M/O Ratio (the “P/E”), prospects for the stock market look pretty dire. A lower valuation multiple (the P/E”) can be neutralized if the “E” is increasing and, alternatively, a lower “E” can be neutralized if the valuation multiple (the “P/E”) is increasing, but trouble awaits when both are going in the wrong direction!

Will Echo Baby Boomers Rescue the Stock Market?

Not all is despair, however, from a demographic perspective. Enter the “echo baby boomers” – latter-day children and grandchildren of the baby boomers (born between 1981 and 1999) — who constitute an even larger number of people than the baby boomers themselves (81 million vs. 78 million). According to Citigroup (page 8), these echo boomers are starting to invest for their retirement, which will boost demand for stocks:

The most fascinating development is the size of the baby boom echo and specifically, the 35-39 year old age group that will be growing meaningfully in the next few years and seems to have an impact on the direction of stock prices.

The age group cited is the cohort of people who have married, had a child and bought a home and is now thinking about their children’s educations and their own retirement needs. Thus, they need to consider investing and they are not encumbered by the substantive equity market losses experienced since 2000 that many of us have endured. They have not suffered a lost decade in stocks and thus do not harbor any ill will to the asset class.

Sounds good, but I would focus on the phrase “growing meaningfully in the next few years.” In other words, the 35-39 age group may have troughed (Figure 16 on page 8), but its resumed growth may not hit a critical mass of new consumers for at least a couple more years. Hmmm….a couple of years gets us into 2014 when Harry Dent says that the market will bottom. In other words, just because the spending of an important age group has troughed doesn’t negate the possibility that the other negative demographic forces discussed above will dominate for quite a while yet to come.

Furthermore, according to JP Morgan (pp. 12-17), the first effects of the echo boomers “coming of age” may not be increased stock buying, but rather increased purchases of homes and durable goods. Stock ownership and retirement saving may have to wait until the necessities of life have been taken of. Although people aged 35-39 may be ready to spend on their families, they are still a decade away from peak spending and their current spending may only beneficially affect a small number of industry sectors (e.g., housing, cars, refrigerators) and not the economy as a whole.

My takeaway: It’s way too early to jump into stocks “all in” with both feet. Over the next couple of years, the economy is primed to remain sluggish and will not raise all boats. Simply buying a stock index fund won’t work. Some industry sectors will do well while others will continue to suffer. What I conclude from the forecasted upswing in the 35-39 age group of echo boomers is that investors should focus on housing stocks (including utilities) and durable goods stocks.

Beyond that, caution remains the buzzword for stock-market investing until these echo boomers tack on another 5-10 years of life and enter the 46-50 and 40-49 “sweet spots” of Harry Dent and the San Francisco Fed, respectively.

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