Monday, 4 October 2010


Manipulative, calculating and infuriatingly effective, Robert Zemeckis' Hitchcockian chiller stars Michelle Pfeiffer as a car crash victim suffering from amnesia and a 'perfect' marriage. Having moved with her scientific-genius husband into a beautiful New England retreat (Harrison Ford in one of his last ever topless appearances), she soon discovers that her new house is haunted, her neighbour is a violent wife-beater and her husband may be a liar, an adulterer and possibly, even, a killer.

Natural and supernatural clues soon lead her to seek answers at the bottom of a nearby lake.  

What lies beneath~~~?  


We too, as investors and hapless victims of an economic car crash, find ourselves being sold a story of recession and recovery which, in some instinctive and intangible way, doesn't quite seem to add up.  

Swirling down the plughole in
October '08, and now...
We're told that we've just been through the greatest downturn since the Great Depression. We're told that the banking system came within days, hours even, of cataclysmic meltdown.  Yet we're also expected to believe that, in less than two years, recovery has taken hold and things are well on their way back to normality.  
Don't worry, it was all
a dream...

Given the long, ugly and well-documented history of banking crises, one of these stories cannot be correct.

The Great Depression was sparked by a banking crisis of similar scale and lasted more than a decade.  It still had America firmly in its grip when it was finally halted only by World War II.  Japan, widely acknowledged as a 'modern-day' depression with similar causes and similar attempted solutions to our current malaise, is now entering its third lost decade of stagnation and deflation.  

The history of the world is littered with banking meltdowns of far, far weaker magnitude than the one we've lived through and almost all of them have taken many years to work out - yet somehow, according to politicians and economists, we are set to emerge without too much more ado into a bright and shining new dawn.  

Now, the public aren't stupid.  Even as they're exhorted to feel better and to buy into the dream of recovery, consumer surveys consistently reveal a deep and persistent lack of confidence in their economic future.  

But there does seem to be a peculiar disconnect between this palpable unease and the evidence of one's own eyes. Aside from swathes of the United States and a few mostly periphal European countries, developed economies have seen only a modest tick up in their unemployment rates. Hardly catastrophic, you might say?

Plus, most homeowners are, despite the headlines, still ensconced within their own four walls and comfortably paying their mortgages.  Indeed house prices in the UK, Canada and Australia to name but three have bounced back powerfully from their battering in 2008.  What kind of a 'depression' is that?  

And eighteen months on from the end of the great stock market plunge, most of the world's equity investors have seen their investments and pensions bounce 60% or more, erasing neary all their losses since the death of Lehman Bros.  Now that the banks are apparently restored to health and the City / Wall St bonus culture is back with a vengeance, it's almost as if Lehman's demise and the near-cataclysm it engendered never happened.

So, was that it?  some of us are compelled to ask.  Was that really the 'Great Recession' we just saw receding in the rear view mirror?  Or does this story of almost instantaneous recovery smell...a little fishy?  Is there something in this tale of economic vitality and bouncebackability which, shall we say, doesn't quite add up?

Is there something, frankly, lying at the bottom of the lake, waiting to shatter our apparently perfect marriage of economic fantasy and reality?

Far beneath the current confusion, the daily push-and-pull between optimism, pessimism and (yawn) double dip-ism highlighted last month in part 1, I believe there lies a deep and immensely powerful undercurrent which may yet determine our economic fate.

You will rarely find it mentioned in news reports.  It is almost never factored into economic forecasts.  It's not remotely sexy and it's a conversation-killer at parties, but knowing just enough about it might over the next few years save you - or quite possibly make you - a cotton-picking fortune.



The claim that any force out there can 'determine our economic fate' will be enough to make any economist's slide rule curl.

It somehow suggests that an outcome is already decided, which would seem preposterous.  Apart from being counter-intuitive it is extremely hard to square with the seemingly random behaviour of markets and the million complex variables which make them tick.  

World GDP since 1700 -
hmm, probably not random
On the other hand we are entirely comfortable with the fact that, over centuries, stock markets and world economic growth have taken a strikingly uniform upward path; but if the short term is genuinely random, gentle reader, does that not mean we must expect the long term pattern to be too?  

British / US stock prices since 1700 -
if it weren't for the log scale the upward
trajectory of this chart would be
Think about it for a moment. Unless we insist that this consistent march higher over hundreds of years is a random occurence, we are compelled to accept the evidence of history that over the long term, world economic and market progress is a natural process - not determined by God, fate, or any external factor but determined by human beings themselves, by their behaviour and the market structures they have created.

None of this should be remotely controversial.  The notion that, as long as certain known and predictable forces play out, an outcome can be so massively probable as to be virtually determined is cold scientific fact: the ebb and flow of tides, the progression of the seasons, these are highly predictable due to the immense mass of celestial objects and the unwavering scientific laws which govern their interaction.  

All this solidity:
just an illusion?
The apparent dichotomy between randomness and predictability exists at every level of our physical universe.  The solidity of a great oak dissolves under the examination of an electron microscope into a ferocious and seemingly chaotic dance of particles.  Are we to say that only the particles are 'real', and that the solid wood is merely an illusion? Or should we simply accept that these two seemingly incompatible states can and do co-exist?  

OK maybe that's one brain-buster too far for an investment blog.  

But given the fact that short-term randomness and long-term predictability are a given in the physical world, let's for a moment entertain the possibility of something parallel existing in the human world, in the economic sphere. 

Let's consider whether, over the long term, there may indeed be a non-random force in play in the world's economy which exists beneath the push-pull of news and day-to-day events; a force which, like a tide working powerfully beneath the choppy surface movements of waves and ripples, may set the general direction of the economy and the overall market trend.

What would such a force consist of?  What could possibly be economically deterministic?  What human certainties could be remotely comparable to those we observe in the physical world?


Yup, these two are pretty much nailed on.  The first, however, naturally assumes two more certainties: birth and ageing.

Now these are hardly inconsequential additions to any list of economic sure things.  Not only does a birth dramatically impact upon a family's spending behaviour, but each new little person is sure to have an impact on the overall economy, not least because they're certain - or let's annoy the economists and say 'destined' - to become a bigger and bigger person.  

Consider the economic impact of each new birth.  Pre-adulthood, young people tend to act as a net drain on the rest of the economy, requiring considerable state and family resources to raise and educate; once into the workforce though, they become progressively more economically 'valuable' and contribute through increasing production and consumption to the creation of wealth.  So birth matters, age matters.  These observations lead one to a further conclusion:

  • our income and spending behaviour at any one time is largely a function of our age and stage of life.  

Is this anything but self-evident?  We know it instinctively from our own experience never mind from plentiful statistical evidence collected by governments and central banks. 

For obvious reasons we are, on average, paid less in our early adult years than we are once we gain experience in later life; we spend those earnings when we're 21 and single quite differently to the way we spend once we're 41, loved-up and weighed down by family responsibilities; we earn more in our middle years as we progress up the career ladder and become more productive; and it's in our highest-earning years that we tend to make the most valuable purchases of our lives - our largest homes, our biggest cars and our major financial investments.  The average earning and spending power of Americans, for instance, peaks at age 47-48.

Consumers, the properties they buy as they age, and the 
properties others build to serve them 

As we sail on towards retirement, circumstances and priorities change: children leave the nest, leading to a levelling off of spending and a rise in saving...

Source: NYTimes
Once in retirement, income levels downshift along with attitudes to spending, which leads to a natural fall off in consumption and a drawing down of savings.  

At its most basic level, this is the story of our lives.  This pattern, this hill-like progression in earning and consumption, is (with many subtle variations of course) common across nations, across cultures and across decades.  Our economy has evolved to serve our needs.  It does not exist separate from those needs.  

Consumption makes up almost ¾ of United States GDP, with Britain and Europe not far behind.  Ordinary people's spending power is what made the west's economic engine the monster wealth creator it has become, yet it only takes a tiny lapse of perspective for us to imagine we're nothing more than bystanders in some great drama starring Ben Bernanke, Fred 'the shred' Goodwin, Dick 'the prick' Fuld, their banking buddies, the politicians in their pocket and a million sweaty traders shouting "sell."  Nonsense - without our ability and desire to spend and invest these people are nothing.  

The economy is not some runaway train in which we sit passively strapped into the passenger seats.  

We are the economy.



Any functioning market economy will expand and contract in response to consumer demand.  When, for example, large numbers of people move into a newly-fashionable area, local businesses grow, hire new workers, become more profitable and pay higher wages.  Existing homes become more expensive while developers and construction companies sense an opportunity and move in.  Estate agencies spring up. 

Just another banker's wife
As younger people form families in the area, new and improved schools are required, childrens clothing shops appear and larger homes are desired, built, extended, dug out and traded up to.  Cafes, bars and restaurants sprout on every corner to waste the endless days and occupy the long evenings of yummy-mummies who can't cook, cool-eyed wannabes and bored bankers' housewives.  Local writer Richard Curtis knocks up a script and sends it to Hugh Grant.  You know the rest of the story.



See where I'm heading with this one?

If a population can grow and the economy turn in one corner of west London from earthy and run down to scrubbed up and filthy rich in two decades (I know, I was born there), what do you imagine is likely to happen to the western world's moribund and war-torn economy once millions upon millions of couples decide to start having babies all at once?

Not only did Americans, Brits and Europeans go hard at it after World War II, they kept at it for almost twenty years, creating the biggest population explosion in human history.  

Between 1932 and 1964, America's birth rate doubled

The story was replicated, as it were, across almost the entire developed world - Japan excepted.  We British were slightly less rampant but no slouches in the baby-making business.  The French, Spanish, Germans, Greeks, Canadians, Australians and Scandinavians all got on the love boat which meant that, from Athens Greece to Athens Georgia, from New London, Connecticut to London Bridge, a great and growing bulge of new people were growing up at almost exactly the same time, millions of new hungry mouths all at once demanding

separate bedrooms, 
university places, 
rental accomodation, 
book stores,
clothes shops,
small cars, 
first jobs, 
first mortgages, 
one-bed apartments, 
bigger cars,
two-bed homes,
D-I-Y stores,
three-bed homes...

You get the picture.

Looked at in this light, it's not hard to see how the post-war baby-boom had a seismic impact on our economy.  It was the most important factor in our post-war wealth boom by far, the modern-day economic equivalent of a celestial big bang.  In the quarter century since the original boomers entered their peak earning and spending years (between the ages of 45 - 50), demand for goods, services, housing and employment simply exploded.  

I believe that the impact of the baby-boom has been and continues to be the defining economic and social event of our times.  From the first wave of young boomers hitting the sidewalks of Motown, Haight Ashbury and Carnaby St in the mid 1960s to the back-end wave of debt-laden middle-aged boomers littering the pavement cafes of Notting Hill, they engendered a social and economic revolution which will continue to affect our lives, for good and ill, for decades to come.  

It is this great tide of middle-aged consumption - a tide of home, car and technology buying super-charged during this last decade by cheap credit, a tide of economic demand which has been washing in to our shores relentlessly for the best part of thirty years - which is finally beginning to ebb.  This was not and is not only a story about debt, greed and financial fraud, folks.  

It's about numbers.

Here is the US population as it stood at the last official count
10 years ago.  See that bulge in the 35 - 39 yr-old cohort?
Those folks are now pushing 50.  Bringing up their rear are a much
smaller group of 'baby-busters' - almost 20% fewer in fact.
That's a whole lot of lost purchasing power.

Indeed my view, backed up by an ever-increasing weight of academic evidence, supported by documented real-time forecasting success and by plain and simple common sense, is that the life-journey from young adulthood to maturity of the western world's vast baby-boom generation was the tide that brought in our economic boom - and that their next life journey is the tide which is now taking it out. 

The UK population 2010.  That big bulge right in the middle is our baby boom generation, now in their late 40's.  Just behind them (ie. to the left) is a substantial fall-off in numbers, a decline which will last a decade.  You can see a great moving graphic of this and other countries' baby booms by clicking this link

It is the magnificent certainty of this generation's journey towards retirement and old-age which is  key to understanding, forecasting and profiting from what happens next.



To try and figure out the economic impact of these shifting demographic tides, the stat boys have been busy crunching numbers and creating models.  What is startling about their findings is the fact that, despite looking at the situation in a series of quite different ways, the overwhelming conclusion of various academic studies is broadly the same.  We're in shtook.


Harry Dent, through his bestselling books in the 1990s and 2000s, first highlighted the economic effects of demographic ageing to a broad public.  Building on the foundations of demographic research first done back in the 1950s, he narrowed the focus onto middle-aged baby-boomers in their late 40s (the top earning and spending cohort), using their growth in numbers as a tool to predict the economy and the direction of the stock market.

Using births shifted forward 48 years on the timeline, boomers
reached a natural peak in spending around 2008.
(Since this chart was published the Dow (black line) has recovered about half of its previous plunge - just in time for the spending wave 

to turn decisively lower).

Dent came up with the 'spending wave' chart, in which a country's population profile is shifted forward on the timeline by 48 years to discover when to expect a peak or trough in economic activity courtesy of this crucial age group.  In his book 'The Great Boom Ahead', in the midst of early 90's recessionary gloom, he boldly forecast the huge boom of the late 1990s and 2000s using this alarmingly simple methodology, predicting at the same time that it would turn to bust in 2008.  

According to this method, a trough in boomer spending - and the end of our economic and market malaise - will finally occur around 2022.

David Rosenberg, the highly respected and widely followed former Chief Economist at Merrill Lynch, recently devoted some research time to this theory and wrote it up in his newsletter.  Here's his take:

Rosenberg broadened the age cohort in his study to include 45 - 54 year olds, but the conclusions he reached were essentially the same.  This big-spending bracket, the backbone of our consumer-led economy, are now declining in numbers and will not begin to recover their strength for another decade.

Above the horizontal line this cohort is growing in number, while below zero it is falling.  These folks are our major spenders, supporting the prices of the biggest purchases we make, cars and houses.

These heavyweight spenders are the ones who borrowed and splurged on homes, cars and consumer luxuries like there was no tomorrow.  By the late 2000s they were saving virtually nothing.  These men and women, burdened with huge mortgages and staring at an uncertain jobs market and decimated pension pots following two huge stock market downturns, are currently pulling their investments out of stocks at an unprecedented rate.

Many commentators have expressed surprise at this development and continue to urge their clients to buy 'cheap' equities.  But viewed through the proper lens - one that understands how a person's age inevitably affects their decision-making - this behaviour is not surprising in the slightest.  After all, if you were pushing 50, would you risk your retirement savings in a stock market which has plunged by half twice in ten years?


Other researchers have looked at the figures a little differently.  Diane Macunovich, currently a Research Scholar at Germany's IZA Institute of Labor, has been investigating the subject since her time as an economic consultant for municipalities and property developers in Canada during the 1970s and '80s.

Her work, much of it published in a 2002 book 'Birth Quake: The baby boom and its aftershocks',  has focused largely on young adults in the household formation stage - those currently in the 20 - 24 age range.  She appears to have found a highly significant relationship between the onset of US recessions and the size of this group as percentage of the total population.

Smoothed rate of change in population share of 20-24 year-olds.
Vertical lines show the onset of US recessions - with the last line

projecting a possible recession in 2012

The 20 - 24 age group is particularly important because historically this is the age at which we begin to buy apartments and starter homes, as well as having a larger share of our incomes available for discretionary spending.

As the proportion of these young spenders and first-time buyers begins to fall, it consistently seems to act as a trigger for recession.  She has noted this relationship holding across many different countries over the past half century and finds it to be statistically significant.  

By contrast, Japan's share of young people fell during the mid and late 1990s even while the west's was rising, a decline in demand which contributed heavily to their 'lost decade'.  

I'd also note that Japan's population of late 40's adults plunged in that period as well, so the double-whammy would have had an particularly deleterious effect on growth.  This is the prospect we in the west are facing right now.

Macunovich's hypothesis is that businesses tend to project a rising trend of consumption into the future when the demographics are favourable (ie. while their customer base is increasing) and they plan their spending and borrowing based on this assumption of continued expansion; they're then taken by surprise when the trend reverses.  As the numbers of new customers declines they are forced to cut back, slow production and lay off workers, tipping the economy into recession.

She notes that their population share has begun a decline into the middle of the decade after which it will slowly recover, and she expects another US recession to occur by 2012 when the growth rate of this group actually turns negative.


The issue of determinism I touched on earlier is tackled in a 2002 Yale research paper by John Geanokoplos et al. entitled 'Demography and the long-run predictability of the stock market'.

Their research leads them to conclude that when you introduce demographics into capital market models...

..."A striking outcome ... is that the future course of stock prices becomes to a significant degree predictable.  Security prices are to an important extent pinned down by the relative numbers of agents in the population who are in different stages of their life cycle."

Their model centres on the ratio of a young population cohort (20 - 29) to a middle-aged cohort (40 - 49).  This they call the Middle-young ratio, and in the US it looks like this:

Demography and the long run predictability of the stock market, Cowles/Yale, 2002

When the line is rising the middle-aged population is growing relative to the younger generation, and vice-versa, implying growing productivity trends and greater numbers of middle-aged workers ploughing their money into pensions and the stock market.  This model caught superbly the period of the 1966 - 1982 market slump and economic downturn, and it is now forecasting a continued funk which won't bottom until late in the coming decade.


In this post we've been looking at our current predicament purely in terms of demographics.  If that were the only problem we faced it would be daunting enough.  Looking back to the 1970s, the slump in various population cohorts contributed to a lost decade for stocks and interminable economic strife.  Yet for all our problems back then, we did not face the overwhelming debt problems developed nations are grappling with today.

US total household debt (blue) and mortgage debt (red) since WWII

The debt bubble has burst but there's a long long way to go yet

I believe that the combined effect of these two profound factors - a slump in demand caused by ageing and increasingly risk-averse baby boomers across the developed world (plus a decline in demand from younger home-buyers and discretionary spenders), in combination with the  creeping government, business and household debt crisis - is creating a lethal financial cocktail that central bank alchemy can not ultimately detoxify.

This is why talk of a 'double-dip' is almost beside the point.  A dip suggests a brief dunk in the slime, followed by recovery.  What we are looking at is a major reset of the world's economy over the next ten year period.  Those who try to call the bottom in asset prices and buy property or stocks before these great forces have worked themselves through are likely to have their wallets handed to them along with their heads.  

For almost thirty years, financial caution sucked; it paid big time to take risk and assume that "all's for the best in the best of all possible worlds".  For the next few years I believe it will pay only to assume the worst.  The time for overwhelming optimism and bullishness will come again, but only once asset prices have fallen to levels few believed possible and deep and abiding pessimism has overshadowed every part of our economic and investment landscape.  That time is some years away.

Until that point, dear reader, I would like to suggest you keep your powder dry. Nurture  cash.  Distrust risky assets.  When you spot a market rally, rent it by all means - but do not own.  Avoid being sucked into the housing market if you possibly can until prices drop further, stay low and the market seems to be permanently beaten down, dead and without hope.

At that point most of the greed-is-good generation who main-lined on blind optimism and credit will have lost their money and have nothing left to invest.  That, friend, is when you and I will be able to step in and make our fortune.


In next month's post, out Sunday November 7th, I shall take a thoroughly positive twist and investigate which parts of the world, which markets and which classes of investment hold out the greatest long term prospect of giving us a standout return on our money in the years and decades ahead. 

Until then, have a great month!