One of the great existential debates about U.S. equities is essentially demographic in nature. Nic Colas, of ConvergEx, asks the question, will retiring Baby Boomers cash out of stocks in the coming years, leaving lower valuations in their wake? At least one recent Fed paper pointed to an 8x earnings multiple for stocks – down from 14x currently – in 2025, all due to the changing face (and age) of the typical investor. But all this doom and gloom only fits if every generation has a similar risk tolerance. If younger cohorts – dubbed Generation X and “Next” – have higher risk thresholds, they may actually buy more equities than their parents, alleviating the demographic time bomb behind that dire Fed prediction. Getting a fix on how these nascent investors will evaluate the risk-return tradeoff is tough; they still don’t have much money to put to work. Still, some signs exist. Believe it or not, a third of young Americans have tattoos, an acknowledged sign of risk-loving behavior. And if you think that is just bad decision-making, consider the business rock-stars of the under-30 set. This latest wave of billionaires are all outsized risk takers, and role models to their generation. Stocks may not be dead just yet.
Nic Colas, ConvergEx; Tattoo You, But Not Me
One of the most powerful bearish arguments against U.S. stocks is not another European debt crisis or a collapse of confidence in the Federal Reserve or a hard landing it China; it is demographics. Simply put:
- As Baby Boomers retire over the next 20 years they will slowly but surely shift their asset allocations from equities to fixed income instruments. The resultant drain of capital will compress valuation multiples, regardless of the level of interest rates or the growth in corporate earnings.
- I should note that this theory is pretty far from the mainstream, but that hasn’t prevented inherently conservative organizations like the Federal Reserve from developing forecast models to project future Price/Earnings multiples based on the age of the retail investor base. The reason it strays from financial orthodoxy is because you don’t factor in the demographics of a buyer when you do a discounted cash flow. Even if the original purchaser doesn’t live to see the final payment of a bond coupon, for example, they can still sell it to someone who will.
- The San Francisco Fed did precisely this demographics-based analysis last near, calling for a trough P/E multiple of 8.3x in 2025 for U.S. stocks. That essentially means that U.S. corporate earnings could grow 5-6% per year for the next 13 years and domestic stocks would be no higher than they are today. See here for the entire text: http://www.frbsf.org/publications/economics/letter/2011/el2011-26.html.
The problem with this analysis is that it assumes every generation has a similar risk tolerance profile. The children of the Baby Boom (1946-1964) – Generation X, born from 1964 to 1982 - are assumed to have the same risk threshold as their parents. And what is being called “Generation Next” – those born from 1983 onwards – should have the same risk profile as their parents and grandparents. If these future generations have greater appetites for risk, then the Fed analysis is too pessimistic. They will own more stocks than the prior generations, thereby diffusing some of the demographic time bomb of Baby Boomer stock sales. And, of course, if they are more risk-averse then the Fed might be too optimistic.
Searching through a Pew Research Center report from 2007 on “Gen Next,” an odd fact caught my eye – more than a third of the respondents reporting having a tattoo. Yes, there is a lot of other information in the notes about this survey (see here: http://www.people-press.org/2007/01/09/a-portrait-of-generation-next/). But seriously – a third of people from the ages of 18-25 are inked up? That’s a lot more interesting than the fact that this cohort wants to get rich, thinks very little about religion, or thinks that government does a good job (all of which are actually conclusions of the study, by the way).
Now, if you happen to have a tattoo (or two, or three), don’t take this the wrong way, but… tattoos are a highly reliable indicator of risky behavior. There are numerous studies in well regarded social sciences publications (see here: http://www.sciencedirect.com/science/article/pii/S089932890100061X, and here: http://www.sciencedirect.com/science/article/pii/S1054139X02004469, and here http://www.jfponline.com/Pages.asp?AID=4762 ). OK, the last one is really more about body piercing, but the idea is the same. Teenagers and young adults with tattoos are significantly more likely to engage in risky behaviors such as intravenous drug use, risky sex, and smoking. There is, of course, a big ‘Correlation/causation” problem here. Do risk-loving young people cluster around the tattoo parlor because they see it as adventuresome? Or do they simply get a tattoo as a matter of social solidarity with their like-minded friends? Hard to know. But take one look at the Google Trends data for the number of people searching the phrase “Get a tattoo” – we’ve included the chart below. As you might guess, it is essentially straight up and to the right.
That Google data also reveals some unexpected information about where these tattoo searchers reside. It is not in New York or Los Angeles, which is where I expected to see the majority of the pings. Nope – the top state for tattoo searches is South Caroline, followed by Iowa, Oklahoma, North Carolina, and Nevada. By city, Las Vegas is #1, followed by Charlotte and San Antonio. NYC is a distance 7th. Bottom line – tattooing is not a bicoastal beatnik/rebel thing. It is an American as hot dogs and apple pie. Or a nicely inked “Mom” on your upper arm.
While this might seem a frivolous exercise, I think the tattoo anecdote does yield something useful in the discussion about risk tolerances by generation. OK, if you want something boring, consider how every generation finds their new billionaire.
Ancient: Henry Ford. Build a huge company in the 1920s. take it public in the 1950s.
Old School: Warren Buffett, investor. Focus on value for the long term. Don’t worry too much about any 10 years period of returns.
Baby Boomer: Bill Gates. Build a dominant software platform, grow with the industry. Don’t change too much one you get in the lead.
Generation Next: Mark Zuckerberg. Build something, retain all the control you can, only go public when the regulators say you have to. Change stuff all the time.
To my mind, both Generation X and Next have some distinct gearing to higher risk tolerances relative to their predecessors. It’s not just the tattoos, of course. It is the desire to work at the “Right” startup if you are a top-flight computer science grad rather punch a clock at a larger company. Or start your own business in college, as several notable tech business stars did. How and if this translates into greater (or lesser) levels of equity ownership remains to be seen, of course. But the demographic destiny of U.S. stocks isn’t as preordained as the most bearish analyses would indicate.