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January 13, 2012

Market Valuation Using the M/O Ratio (Updated)

by HigherAlpha

An interesting study using the M/O Ratio, which is the ratio of people in the Middle (40-49 years old) vs. Old (60-69 years old) age cohorts, reveals two things:

1) High correlation/predictability of the market P/E ratio during the last 50 years.
2) Future market valuation will come at a lower P/E valuation.


Rationale

The rationale of the M/O ratio is that the Middle age cohorts have a higher risk profile compared to the Old age cohorts. The Middle age cohorts are the ones who are accumulating wealth and investing into the markets. The Old age cohorts are those retiring — taking money out of the market and reallocating risky investments into safer ones such as fixed income. A high M/O ratio would imply an excess of demand in the equity markets compared to the supply of extracting wealth away from the market.

Predictability of the M/O ratio is very high using population statistics. With high confidence in predicting the M/O ratio and the high correlation between the M/O ratio and the P/E ratio, we can derive key implications about the future valuation of the stock market.

The wave of the M/O ratio was significantly impacted by the baby boomers of the post WWII era. Now that they’re retiring, the opposite effect of what these boomers brought to market valuation is occurring. It’s a basis of supply and demand, and it’s just reality.

Middle Age Cohorts Analysis

The Middle Age cohorts will only decline 8.8%, which alone give a 8.8% P/E de-valuation over the next 10 years (or ~1% a year).

Old Age Cohorts Implication
Since the Middle Age Cohorts are only dropping 17% over the next 10 years, the Old Age cohorts must be increasing. This leads to a conclusion that there is a large amount of incoming retiree group in the distribution of wealth to owner age cohorts. Of the 50% decline we’re expecting in P/E valuation, the data suggests that 80% of that would come from the increasing Old Age group rather than the decreasing Middle Age group.

Implications

The model-generated path for real stock prices implied by demographic trends is quite bearish. Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. The subsequent recovery is quite slow. Indeed, real stock prices are not expected to return to their 2010 level until 2027. On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010.

Since the M/O Ratio is expected to fall 50% in the next 5 years (2012-2017), the S&P 500′s earnings must go up 100% for the S&P 500 to trade the same price as today since the M/O Ratio expects the P/E ratio in 5 years to be half as high. According to S&P 500 earnings growth rates, we’re looking at EPS growths of 25-30% per year. That means there will be high pressure against the market to keep the current S&P 500 valuations.

However, there are still opportunities to make money investing long in the markets. For example, P/E ratio is much more volatile historically than the M/O ratio, so opportunities are there when the markets sells off such as during a market crash.

There are also implications in the long term that the M/O ratio is expected to turn around starting 2021, which could open up to very lucrative following decades. If you are not in your 40′s yet, this implies that as long as grow your wealth modestly and preserve capital for the next 10 years, you will be able to participate in what potentially be a very huge bull market like the one seen in the last two decades before the dot-com bubble bust.

It is still important to keep in mind of the future of the market’s valuation and invest accordingly. With key trading and investing education that this site provides, you should be able to invest your money prudently and beat the market in the long run. Stick around with Higher Alpha and be rewarded with market-beating knowledge, trading education, and a proprietary data you can count on to make money in the markets.

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