What Can Cause CAPE To Tumble?
Most of the explanations we have discussed for the rise in the CAPE ratio are inherently temporary and are subject to the risk of mean reversion The CAPE naysayers tend to focus on the reasons why a high CAPE ratio can support a high return and tend to ignore the reasons this may not be the case. Let’s look at what could cause the equilibrium CAPE to fall back toward, or even below, its long-term average, causing the current level of CAPE to tumble. We identify two major structural changes that could push CAPE lower: the demographics of an aging work force and further changes in EPS growth.
An Aging Work Force
The population of the developed world is aging, which is putting pressure on economic growth as well as producing headwinds for valuations. For much of the second half of the 20th century, developed economies enjoyed a rising support ratio, or a growing working-age population relative to nonworkers (children and retirees). Arnott and Chaves (2013) pointed out the confluence of demographic conditions that created several decades of economic benefits: the population of children tumbled; the work force was dominated by young adults, rapidly ramping up their productivity as they honed their skills; and the number of senior citizens was small, drawing only modestly on the GDP produced primarily by the young work force.
Although fewer children benefitted earlier generations, today it means we have fewer younger workers in the economy relative to older workers. Peak earning power, and hence peak productivity, typically occurs for workers in their 40s or 50s. For workers beyond this age, the growth rate of productivity is at its smallest, eventually turning negative in the final years of work, and starkly negative when the person enters retirement.
In 2010, the United States had roughly 4.5 working-age people (ages 20–65) for each person of retirement age. By 2030 this ratio is expected to fall to 2.7. Arnott and Chaves (2012) showed that GDP growth is propelled by young adults in their 20s and 30s, and is hurt badly by a population with a disproportionate share of senior citizens. In 1950, the average age of the US population was roughly 30, and one in eight adults was a senior citizen. Today, the average American is 38 years old, 20 percent of the population are seniors, and both figures are rising quickly. The reduced productivity associated with an aging population, combined with a falling support ratio, should be a powerful force slowing economic growth and associated EPS growth.
Post-WWII demographics have also had an impact on investments. As the baby boomers aged, many realized they weren’t saving enough for retirement and became valuation-indifferent buyers (either directly or through their pension programs), even willing to accept negative real returns, as they urgently accumulated financial assets in order to have money to buy goods and services in retirement. Are these buying pressures from soon–to-be retirees contributing to the recently high CAPE ratios? Our research would support this thesis.
In retirement, the baby boomers will likely choose to de-risk, first selling their equities in exchange for safer assets, then becoming valuation-indifferent sellers, willing to sell regardless of price or yield because they need to convert financial assets into consumption goods. This de-risking should push stock market yields higher and CAPE ratios lower, and eventually push real bond yields higher too.