Scary Story: Global Stock Declines and the Baby Boom

In the past decade or so, an economist asked to tell a horror story over toasted marshmallows at a cookout would not have conjured up empty McMansions haunted by subprime ghosts (though in retrospect that would have been a pretty good tale). Instead, among friends if the mood was right, we might say to each other in a spooky voice “think what will happen if the baby boomers all decide to cash in their stock investments at the same time!” Followed by nervous laughter and a quick change of subject.

At first blush, it seems that we were barking up the wrong tree. Today’s global conflagration originated in the market for subprime mortgage securities, which has little evident connection to boomer retirement investment decisions. It is easy to follow a direct chain of links from the subprime sparks that first flared in the spring of 2007 all the way through to last week’s stunning losses in stock markets around the world.

The problem with this narrative is that it is like explaining a devastating forest fire by reconstructing the exact pattern by which sparks jumped from one stand of trees to another, when the key question is really why the forest was so flammable in the first place.

Put it another way: Last week’s massive losses on global stock markets cannot plausibly be attributed to lingering concerns (however justified) about the creditworthiness of American subprime mortgage-backed securities, because the amount of vanished global wealth dwarfs the value of all the subprime mortgages put together. Something else is going on.

That ‘something’ is probably best described as a sudden sharp increase in global risk aversion. It will be weeks or months before a clear picture emerges of who is fleeing risk, and why. But when the dust settles, I am guessing that the answer will be clear: The recent rout has been driven by too many baby boomers and retirees (not just in America but around the world) trying to crowd through the risky-asset exit doors at the same time.

The reason economists have been worried that this might happen is that personal finance books are right when they advise people to reduce their exposure to financial risk as they age. As your marketable skills diminish over time, you gradually lose the option of going back to work in response to a bad financial shock. The rational thing to do is to reduce your exposure to financial shocks with age.

In a population with a stable age structure, these portfolio shifts can be accomplished without even a hiccup in market prices; older people with a declining appetite for risk just sell their stocks to the equally large up-and-coming younger generation.

But a baby boom demographic bulge is like a hamster eaten by a snake: The hamster is so large that it distorts the snake’s body on its way through the digestive tract. Similarly, perhaps the movement of the baby boom bulge through the financial system has led, at least in part, to the recent dislocations.

In detail, the story might go as follows. When the baby boom hamster reaches middle age and accumulation of home equity and retirement savings are at their peak, boomer demand bids up the prices of homes and stocks (perhaps also causing a housing construction boom). Then, approaching retirement, the boomers all try to downsize from their empty-nest homes and switch from stocks to safe investments at roughly the same time, setting off housing price and stock price declines.

Economists have treated this scenario as an implausible campfire story rather than a sober economic forecast for several good reasons. First, despite many attempts spanning several generations of researchers, it has proven difficult to find the expected kinds of demographic effects in aggregate saving data; for example, since boomers’ late middle age should be their peak saving years, we should have seen an increase in the American personal saving rate over the last decade if demographic shifts drive aggregate saving. But saving rates have declined. Furthermore, with the baby boom generation so heterogeneous (spanning a 20 years of birth dates, in varying states of health, and with diverse preferences for risk), it seemed that changes in risk preferences should be gradual enough to prevent destabilizing “stampede” effects – especially with foreigners (until now) willing to step in and buy the risky investments as the aging boomers sold them. Finally, the timing seems wrong – one would expect a boom in housing before the boom in stocks, the opposite of the pattern we have seen.

Nonetheless, it seems increasingly plausible that the financial panic has pushed a lot of boomers and recent retirees over a tipping point of concern; they’d been thinking for years that it was time to start reducing their exposure to that risky stock market, but never quite got around to it. Now everyone wants out at once.

Here’s a fact that lends some credence to this story: 2008 is the first year that any members of the American boomer generation have been eligible to receive Social Security retirement benefits. The really scary thing is that 2008’s trickle of retirees is just the start: The wave of retirements coming in the next decade will exceed anything ever seen before.

The one reassuring thing about this explanation is that it provides a rational, testable reason for the recent frightening events, and also provides a reason to believe that the damage will be contained. The stock market fell by 89 percent from its peak in 1929 to its trough in 1933, a decline that was not driven by a rational force like demographics. In fact, if everybody who was sitting on the fence until last week has now jumped off, maybe there is reason to hope that stock prices are close to a bottom, from which they can resume a more normal pattern of growth.

Only time will tell.

Originally published at the FT and reproduced here with the author’s permission.

4 Responses to "Scary Story: Global Stock Declines and the Baby Boom"

  1. IntoTheBlack   October 14, 2008 at 12:22 am

    The “pig in the python” has been the basis of Harry Dent’s ( investment analysis for over a decade. He’s now forecasting a long recession. While there’s definitely some fluff in Harry’s analysis, a lot of it makes a lot of sense.

    • guest   October 14, 2008 at 4:27 am

      You are right, Harry Dent’s book “the great boom ahead” , published in 1993 predicted the 1994-2007 boom linked to the spending wave of baby boomers reaching their most productive years. He also predicted the long japanese stagnation also on demographic grounds (no baby boom in Japan after WWII), and also predicted the end of the boom around 2007-2008, as american baby boomers will start retiring and pension fund will start selling stocks to pay for pensions.In fact all the above was written in Harry Dent’s book 15 years ago…

  2. London Banker   October 14, 2008 at 6:37 am

    The mechanism for the rout “risk aversion”, as you call it, was a massive, coordinated margin call on 2-3 October by the JP Morgan, Goldman Sachs and Morgan Stanley prime brokers. They deliberately crashed the global equity, bond and commodities markets to gain the cash margin from the hedge funds that will enable them to fuel the coming bear market rally.They will then “lather, rinse, repeat” until they are profitably recapitalised from their manipulations and everyone else is left with the losses to pension, insurance, money market and investment portfolios.You will note that as this happens (and we are on the fourth round of this “shake out”), the US markets do not fall as far in the rout and rise further in the rally, making for a nice appearance of flight to quality.In a highly leveraged market, as we have today, it is the manipulation of margin calls that is the mechanism for creating routs and rallies – and survivor bias favouring those orchestrating events.

  3. Anonymous   October 16, 2008 at 5:12 am

    Even the original spark for the current wildfire can be traced to the Boomers. As people age they want to reduce house consumption. It may be that underlying the housing boom and subsequent crackup were the boomers and their parents. I see this in the community I’m in, boomers are trading down in housing size, their parents are dying and their housing stock is adding to the unconsumed existing stock. This potent combo of a rush to the exits in both housing and equities is truly fearsome and does not bode well for a “recovery” but rather an adjustment to a new equilibrium. In additional, using Shiller’s data, the S&P is just now reaching its long long long term trend point (about 900) and will likely overshoot downward. The argument could be made that in the big picture we are undergoing a brutal reversion to historic means in both housing and earnings-price equity ratios. Even if the most recent drops are precipitated by hedgies getting clobbered the aging boomers don’t have the wherewithall to buy the ashes. Most succinctly put by my young niece who said “now that my parents and their friends have destroyed the world I might as well buy their stocks on sale and look forward to buying more house than I thought I could when it comes time to have kids.” Unfortunately there are not enough of her population wise, at least in US. A corollary to this is Siegel’s idea that as US ages it will sell it’s assets to younger countries abroad. This would match well on a global macro basis with what we see today with China, et al taking on our assets. What a mess!