- Demography and the Long-Run Predictability of the Stock Market
The secular movement of the U.S. stock market in the postwar period has been characterized by three distinct twenty-year episodes of sustained increases or decreases in real stock prices: the bull market of 1945-66, the subsequent bear market of the 1970s and early 1980s, and the bull market of the middle and late 1980s and the 1990s. Explanations of the most recent and spectacular bull market have typically been based on several factors:1 the advent of a "new economy" in which innovations create a permanently higher rate of economic growth and an accompanying increase in the intangible capital of the corporate sector;2 the substantial increase in participation in the market; and the apparent decrease in risk aversion of the baby-boom generation.3 Similar arguments, based on the "new economy" created by the technical innovations of the immediate [End Page 241] postwar period and increased participation in the stock market, have also been used to justify the bull market of the 1950s.4 The period of declining stock prices from 1966 to 1982 has spawned fewer rationales, as documented by the well-known paper by Franco Modigliani and Richard Cohn.5 They argued that real earnings and interest rates could not account for the 50 percent decline in the real Standard and Poor's (S&P) index between 1966 and 1978, and they found themselves forced to conclude that the only explanation for the sustained decrease in stock prices was that investors, at least in the presence of unaccustomed and fluctuating inflation, are unable to free themselves from certain forms of money illusion and therefore look to the nominal rather than the real rate of interest when valuing equity. Although these explanations probably capture important elements underlying the behavior of stock prices in each of the three episodes, they cannot readily be pieced together to form a coherent explanation of the stock market over the whole sixty-year period.
The idea motivating this paper is that demography is a common thread that might provide a single explanation for the alternating bull and bear markets over the whole postwar period. Since the turn of the twentieth century, live births in the United States have also gone through alternating twenty-year periods of boom and bust: for example, the low birth rate during the Great Depression and the war years was followed by the baby boom of the 1950s and early 1960s and the baby bust of the 1970s. These birth waves have resulted in systematic changes in the age composition of the population over the postwar period, roughly corresponding to the twenty-year periods of boom and bust in the stock market.
People have distinct financial needs at different periods of their life, typically borrowing when young, investing for retirement when middle-aged, and disinvesting during retirement. Stocks (along with other assets such as real estate and bonds) are a vehicle for the savings of those preparing for their retirement. It seems plausible that a large middle-aged cohort seeking to save for retirement will push up the prices of these securities, and that prices will be depressed in periods when the middle-aged cohort is small. We find that this is indeed the case in the model we develop in this paper, regardless of whether economic agents are myopic or fully aware of demography and its implications. James [End Page 242] Poterba has argued that, if agents were rational, they would anticipate any demography-induced rise in stock prices twenty years before it happened, bidding up prices at that time and thereby negating much of the effect of demographics on stock prices.6 We show that, in our model, if agents are myopic, blindly plowing savings into stocks when middle-aged, stock prices will be proportional to the size of the middle-aged cohort. But we also show that, when agents fully anticipate demographic trends, their rational response actually reinforces the effect on stock prices, making prices rise more than proportionally to the growth of the middle-aged cohort.
To test how much of the variation in security...