Tuesday, August 23, 2011

A Demographic Forecast of PE Multiples

The San Francisco Fed puts out some interesting research from time to time.  A recent article discusses the effect that baby boomer retirement could have on equity multiples.

In order to look at the effect demographics have on equity multiples, the writers examined the ratio of middle aged population (40-49) to old age population (60-69) in the US.  They dub this the "M/O Ratio."  The thesis is that at middle age the average investor will have a greater risk tolerance and therefore a larger proportion of savings in equities, which should boost equity valuations.  As a person ages and reduces risk tolerance, he or she will tend to shift to fixed income investments, depressing equity multiples and interest rates.  Thus higher (lower) M/O ratios should lead to higher (lower) equity multiples over time.

The analysis isn't particularly complicated, but the results are striking.  The M/O ratio turns out to be a pretty good forecasting tool for long term P/E multiples.

If the authors extend a projection for the M/O ratio through 2030, the forecast for equity markets isn't particularly encouraging.  According to the model, the P/E ratio should bottom at around 8.5 in 2025.  That's a long bear market...

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