Investor Behavior Will Continue to Shape Market Growth
We tend to focus a lot on economic data and projections to predict where markets will be heading in the future. Investor behavior plays a big role in these outcomes as well.
There is no question that economic trends do play a significant role in shaping long-term equity curves, as better economic times mean that there is more money to invest and this will place upward pressure on the prices of equities. Conversely, leaner times mean that there may be more outflows than inflows and this places downward pressure on stocks and other investments.
People looking to assess the future and make projections will take a certain view of what shapes things, which leads to their having a narrower focus than would be ideal. It is not that the insights that may be gained aren’t relevant, for example seeing economic growth surpass the rate of inflation does make it more likely that net gains will be realized with equities, but this does not happen directly and there are other factors involved that must be accounted for.
If we really want to understand where we are headed, we need to focus on the overall process, where we start with more or less capacity to grow markets and then examine how intervening processes may further shape these changes.
An example would be to look at how increases in income may shape increases in wealth. More income provides the means to build more wealth, but this will come down to how much of this income is spent and how much is retained over time. While it’s not hard to come up with a correlation here, the intervening factors, how much we save, is going to matter quite a bit, and these factors need to be looked at as well.
We have a similar situation with trying to predict future stock prices by just looking at economic growth. Economic growth provides the potential for stock market growth, but the path is not a direct one, and how much people invest is going to matter a lot here as well.
The growth in stocks that we’ve experienced over the past few decades has not occurred so much from changing economic conditions as it has from changing investor behavior, and investor behavior has changed a great deal over this time. Simply put, people invest more of their resources in stocks lately and this is the real force behind bull markets.
If we’re just looking at macroeconomic data though, while this may have provided some insight, it’s just not going to be able to explain this phenomenon sufficiently. This is just one of the inputs in the model, and this is an input which can increase or decrease the capacity of investors but the overall will to invest is going to be the real deciding factor, the proximate cause of markets rising or falling when all factors that bear on this exert their forces.
We Tend to Just Look at Pieces of the Puzzle Instead of the Whole Puzzle
In spite of how long we’ve been studying these things, our overall understanding of them still remains pretty undifferentiated and incomplete. While we’re dealing with complex matters, it should not be so hard to understand why stock prices rise and fall over time as long as we at least start at the point where these changes occur, which is actually at the exchange level.
It is not just inflows and outflows that we want to look at, the quantitative side of things, how much money is being put up on both sides of trades, although quantitative changes do influence things quite a bit. More money being put into the system does put upward pressure on prices obviously, and taking money out does serve to influence prices downward.
This can only be properly understood by taking account of what we could call the qualitative side of things, which are the expectations that come with these trades. In order to want to buy a stock, we’re going to need a positive expectation, otherwise the investment is pointless.
We expect that stock prices will go up or down, and we buy and sell stocks based upon these expectations. Positive expectations cause prices to rise, and for them to continue to do rise, this requires that this qualitative expectation be maintained.
People invest over the long term with a long-term positive expectation, and while there are other reasons apart from this expectation that will cause prices to rise, the expectation itself not only plays a central role but is sufficient in itself to cause this to happen.
Expectations do vary over time, but as long as people keep investing and holding their investments with a long-term positive expectation, we will continue to see these expectations being met. If we lose confidence in this over the longer term, this is where the long bear markets come from, but we’re in a position now where we’re so wedded to the positive side that this risk has become significantly reduced.
These expectations have been better consolidated as of late, and we could even say that equity investing has become such a big part of our culture now that we see long-term success as not just something that we are aiming for but something that we actually need in order to prosper in the future. People buying stocks to be able to have enough money retirement is a good example of this, where a lot of people see themselves has having to do this and this requires the positive expectation to be assumed and not even subject to much analysis if any.
We still need the means to do this, and therefore we need to avoid serious and extended economic downturns to pull this off, but at the same time we can’t just look at the economy and assume there is a direct relationship with stock prices, as we often are prone to doing.
Looking at the whole picture should actually paint a pretty bright one for the long-term viability of stock investing, and when we see our economies managed well where downturns are kept to a minimum in both duration and effect, this just adds to our level of confidence, but is not where it is derived from. It is together with this confidence that the whole thing comes together.
When we look at how investor behavior itself may change over time, we need to avoid seeking out overly narrow data such as changes in demographics and look to forecast just from these data. There are people who actually try to do that though, and while these things do matter, they are just one factor among several and we don’t want to just take a piece of the puzzle and say that’s the puzzle itself.
Demographic Changes Can Matter, But This Still Comes Down to Will
One of the things looked at is what is called the MY ratio, which is the ratio of middle-aged people, age 35-49, compared to young people, aged 20-34. This isn’t the way we usually break down this demographic but assigning the categories in this way presumably yield more usable results when we cook this up this way.
We do know that this middle-aged segment will have a greater means to invest than the younger folks, as younger people spend more and save less overall compared to those older. None of this could even be disputed actually.
Why the ratio matters or would even be something we would want to look at is far less clear, as we would normally just want to look at changes in the middle-aged population or any segment that is more prone to investing. If, for instance, one group invests 10% of their income and the other invests 3%, having more people in the 3% group would put the ratio down but it’s very difficult to imagine how this would reduce overall investment.
We don’t always think about such things very much though, and the mere fact that you can come up with a statistic that correlates to our satisfaction is often enough, but using such a thing to predict the future can be another matter entirely. It is not just that we want to predict things to gain insight, we need to be looking to gain as much knowledge as we can and this requires that our models make as much sense as we can manage.
Research companies make money from these things though, and if you can come up with something like this and sell it to people, and especially when this involves a fairly novel perspective, you are certainly doing your job to promote the well-being of the company, even though you may not have made any significant contributions to knowledge.
Alejandra Grindal of Ned Davis Research at least needs to be commended for paying this much attention to investment capacity, and this is a far better view than just looking at the economy and assuming that there is an invisible hand that it uses, as the hands here are indeed pretty visible and measurable.
More often, we look at the middle-age to old ratio (MO), which actually seems to make more sense if we did want to view this in terms of ratios, because we are at least looking at segments which represent opposite ends of the spectrum, with middle-aged people contributing the most to inflows and older people contributing the most to outflows. We save in middle age and spend when we’re old, but we need to get the demographics right here to actually segment them according to these behaviors.
Grindal claims that the MY ratio correlates to the stock market better than the MO one does. The MY ratio is not a new one though, and was put forth about 20 years ago, even though we’re not even sure why this is supposed to work well. We don’t always ask these questions though but we do know that it does make sense that increases in the M side of either of these should correlate, and reductions in Y can mean more people graduating to the M group, although we would think that just observing and predicting M trends would accomplish all of this.
According to Grindal, this ratio has been pretty flat over the last few years but is starting to trend up, and is projected to continue to do so until the mid 2030’s. This could happen for reasons not particularly relevant to the stock market though, such as lower birth rates, and it’s hard to imagine how having a lesser number of young people would have that big of an effect upon the market and especially causing us to come up with bullish forecasts such as this.
Some long-term investors may find solace in these projections, but it is pretty unlikely that having a higher ratio of middle aged to younger working people could influence this very much. There are some better reasons to hold this view though, and the biggest one is that we may expect that, with current demographics together with the will and even need to invest, we will continue to see people putting more and more money into the stock market over time.
It is not the past that makes this so, the fact that stock markets have gone up over the long run and therefore should continue to do so based upon history, it is why this happens, and we’re seeing the why part continue to grow over time, especially over the last decade. The fact that this is set to continue is enough because this is really what keeps us moving ahead.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
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