Why are Americans fleeing the stock market?
It’s a question very much on the minds of market practitioners, policymakers, and journalists, who have devoted much ink to the subject lately. One of the latest commentators to weigh in on the debate is Joshua Brown, a.k.a. The Reformed Broker, who posted his take yesterday in a blog post titled “American Idle: Five Reasons We Hate the Stock Market (warning: his language is pretty raw).
Brown’s five reasons for America’s equities aversion include the fallout from two severe market corrections in a decade; the flurry of market scandals that have shaken faith in market “experts” and institutions; the impact of a stock market and investment industry that are shrinking under the weight of retiring Baby Boomers; the lack of interest in stocks among 20- and 30-year-olds today; and the sense among the general public that those responsible for the credit crash have gone unpunished.
I like the arguments and agree with almost all of them. Nice job, Mr. Brown.
Still, there is one nugget that caught my eye: a piece of conventional market wisdom that is worth exploring in detail. Toward the end of Brown’s post, he offers readers a glimmer of hope by suggesting that the stock market is nearing the bottom, which he says is signaled by the growing crescendo of investor disgust. “We’re not there yet,” Brown writes, “but we are getting very close.” Presumably, his thinking is that valuations at this future point of maximum disgust will be fair, and that money will be more easily won at such levels.
Yet this conclusion rests on two return assumptions: that companies pay you a dividend and/or that stock prices will appreciate. Right now, though, the dividend yield on the S&P 500 is very low relative to history. We would have to see a huge shift in the behavior of chief financial officers (CFOs) in order to see the level of dividends increase much. That assumption, in turn, relies upon generations of business school graduates (who become CFOs) “unlearning” that cash dividends are the least efficient use of capital for businesses. The standard view is that dividends create an income-tax obligation for investors and that companies can prevent this tax obligation being borne by their shareholders by retaining the cash instead. So CFOs are unlikely to change their tune.
What about the notion that prices will rise and generate capital appreciation for stock market investors? That rests on demand for stocks being greater than the supply of stocks. If you look at the history of the “bull market” that Brown refers to as 20 years in length, you will see that the secular bull market actually began in September 1966 with crazy valuations (as measured by negative equity risk premiums). This “Nifty Fifty” period of the market was followed in the early 1970s by a long-lasting correction that abated in 1974 — and then it was off to the races again. The market really only returned to positive equity risk premiums in January 2008.
Why is this difference in the framing of the time period significant?
In 1966, the first Baby Boomers turned — you guessed it — 21 years old. They were just graduating from college and entering the work force. The demographic bubble, in fact, can explain a lot of the excess return of the stock market. This is especially true when coupled with the knowledge that modern portfolio theory and asset allocation, and the enthusiastic Wall Street “YES!” to these theories, began in the late 1950s and early 1960s. People needing to save met sellers of “savings” that offered the stock market as a nice receptacle for their earnings. The rest is history.
Brown does not seem to appreciate that without another demographic bubble akin to that of the Baby Boomers, über excess demand from the successors of the Boomers is required in order to see a return to the stock market’s glory years (not that he says he anticipates a return to the wonder years). I am specifically referring to his conclusion as follows:
Apathy is morphing into disgust, the longer this continues the better. . . . Because hatred and a public perception of endless futility brings about opportunity.
Unfortunately, in a world without the Baby Boomers, we would be looking at an equity risk premium that has averaged a paltry 2.45% since 1881. In the current investment climate, in which a 10-year treasury yields 1.6%, equity investors are looking at returns in the 4–5% range for the foreseeable future. That is hardly enough to generate mass buying. The author essentially misses the significance of his own point about the Boomers: that even with apathy and hatred and a public perception of endless futility, stock market returns are likely to be very hard to come by.
Of course, it’s possible that foreign buyers will flood our equity markets with demand. But where is that next innovation — like the telephone, the airplane, or the Internet — that will drive a shift in the demand curve for stocks, and not just a movement along the demand curve? To be sure, innovation is extremely difficult to identify before it happens. So the point here is that absent a demographic miracle, innovation will have to be even greater than it has been in the past in order to compensate for the drop off in demographic-driven stock market demand.
Unfortunately, we could be waiting a while.
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