In the short run, it's hard to tie market movements to any one set of factors. But when you pull out to see the bigger picture, one way to explain why stocks rise and fall is simply to look at the stock market as an example of basic supply and demand.
That, in a nutshell, is what market researcher Rob Arnott has done, and the conclusion he's drawn from that exercise is alarming. In an interview with The Wall Street Journal, Arnott makes it clear that he essentially believes that the current make-up of the U.S. population will keep stock market returns low for at least the next decade.
Understanding the demographics
Arnott's basic argument is simple: The baby boom generation is now entering its retirement years. As more people retire, they'll stop accumulating wealth in retirement accounts and instead start to spend down their assets. In the process, they'll necessarily sell off some of their investments, increasing the supply of stocks on the secondary market and thereby keeping prices in check.
As evidence for this argument, Arnott points to two prior phenomena. In Japan, a similar demographic bump occurred 10 years earlier than in the U.S., and that nation is still facing a tough stock market environment more than 20 years later.
Meanwhile, the boomers have already made their presence felt in previous market cycles. During the 1980s and 1990s, the mass of mid-career workers entering their peak earning years pushed stock prices to extremely high levels, creating unrealistic return expectations.
Revisiting an old argument
Arnott isn't the first person to look at this demographic phenomenon. Last summer, a report from the Federal Reserve Bank of San Francisco examined the potential impact of baby boomers on the financial markets and came up with a similar conclusion: Earnings multiples for the stock market will continue to contract for the next 10 to 15 years, only then starting to rebound as the relatively small Generation X gives way to the echo-boom of the millennial generation.
But in many ways, Arnott's answer to the problem is more constructive. The San Francisco Fed's study seems to suggest that there's nothing to do but wait out the coming storm -- or hope that retirees won't spend down all of their assets and therefore provide a floor to any drop in stock prices. But Arnott argues that international capital flows aren't as reliable as some might think, and therefore, investors can look to economies with more favorable demographic characteristics as better long-term investments.
What to do
With Japan, Europe, and the U.S. all sharing aging populations, emerging-market investments look more attractive demographically. That would point toward investing in Baidu (NAS: BIDU) , as the premier play on growth of the Internet both in China and potentially throughout the Asian region. It would encourage owning Arcos Dorados (NYS: ARCO) as a play on consumer growth, as it operates the largest Latin American network of McDonald's (NYS: MCD) franchises. And it would support broader-based investment in iShares MSCI Brazil (NYS: EWZ) and similar country-focused ETFs for emerging-market nations.
But the challenge there is that emerging-market stocks have become a favorite pick among U.S. investors. Inflows into emerging-market funds are extremely strong right now. If retiring boomers reverse those flows, then emerging-market stocks could get hurt -- unless domestic investors in those nations can pick up the slack.
I think the better answer is to look toward the investments that retirees are likely to stick with as long as possible. Intel (NAS: INTC) , for instance, combines an unusually high dividend for a tech company with the potential growth from the chip giant's entering the mobile market. McDonald's will benefit from emerging-market growth at least as much as home-market companies in those markets, and it has given shareholders the attractive combination of stable returns plus dependable income over the years.
Predicting the future of the stock market almost certainly isn't as simple as a simple supply and demand equation. But staying aware of demographic arguments can help you gain a longer-term perspective on the various trends that will affect your investments in the years to come.
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At the time this article was published Fool contributor Dan Caplinger hopes to benefit from those demographic trends one of these days. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Arcos Dorados and Intel. Motley Fool newsletter services have recommended buying shares of Arcos Dorados, Intel, McDonald's, and Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never loses.
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