The Boomer Effect:  Market Disaster Or Arbitrage Opportunity?

By Daniel R. Amerman, CFA

This article is available as an audio recording, or text transcript.  In the interest of brevity, this article assumes a degree of financial sophistication on the listener’s part, including understanding the basic theory behind futures contracts.

Take A Walkabout Into Your Future, In The Shoes Of The Person Buying Your Investments....

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Transcript:

Hello, my name is Dan Amerman, and welcome to The Great Retirement Experiment.   What happens to the investment markets when 77 million Boomers retire may seem to be a depressing subject, but this is a problem that also carries some major opportunities with it. 

The reason to study the Boomer effect, the numerous and interrelated investment market effects of the largest generation in history reaching retirement age, is that it may constitute the largest potential arbitrage opportunity that we will see in our careers.  For the serious or professional investor the Boomer effect represents an absolutely textbook case of the futures contract on an asset trading at a different price than the fundamental value of the asset itself. 

Lets’ revisit what happened in October of 2006.  Fed Chairman Bernanke starts the month with a major speech in which he indicates that demographic changes are likely to be the single most important influence on the economy in the decades to come.  He asserts that the declining number of workers as a percentage of the population will likely decrease the growth rates for per capita GDP, decrease the growth rate in living standards, and decrease the growth rate in consumption.  The same month, the head of the Government Accountability Office, David Walker, is touring the country talking about the quote unquote “demographic tsunami”, that is rapidly approaching, and the potentially catastrophic effects of that Boomer tsunami for Medicare and the budget deficit.  Also in October, the Economist magazine publishes an article entitled “The Slow Road Ahead”, where they talk to a number of economists about the economic impact of this upcoming fundamental demographic change, and discuss the possibility that there may be a new quote, unquote, speed limit for economic growth, of perhaps around 2.5% per year.  This represents a major drop from recent assumptions of long term 3-3.5% real annual GDP growth.

A 1% drop in growth rates from 3.5% to 2.5% is huge, when we look at the long term economy or markets.  Because it is a reduction in an exponential compounding rate.  Going to 2.5% growth rate over a 30 year time period means about a 25% reduction in the size of the overall economy, compared to what it would have been with a 3.5% real GDP growth rate.  And that will be just the beginning.  Because we have a cost structure for Boomer retirement that is theoretically somewhat fixed with Social Security, Medicare and pension promises.  Less money available in the overall economy, means that these promises will consume an even larger share of the economy, and there is still less money is available for consumption – or buying investments from Baby Boomers.  Either that or walk away from more promises to Boomer retirees – which then also means less money for consumption because of a reduction in retiree income, or an accelerated rate of sale for Boomer investments.  For all of these factors wrap around each other in the intertwined world that will be the Great Retirement Experiment.

An equities market that continues to trade at some of the lowest dividend ratios in financial history, should have a hair trigger sensitivity to changes in long term economic and earnings forecasts.  With an average dividend of under 2%, price appreciation based upon growth is really the only long term fundamental you have, for justifying current price levels.  So how do the markets respond?

By setting new a five year high of course, with the Dow breaking through the record set in 2001, in nominal dollars anyway. Seeming completely ignoring the increasingly bleak long term growth forecasts from increasingly prominent officials and economists.  Almost as if the market was collectively ignoring the long term economy itself, or found it to be irrelevant.

Some academics might find this to be a somewhat shocking assertion.  For it would seem to contradict the idea that behind Efficient Market Theory, with that hypothetical group of super-rational investors who always collectively make sure that the markets are fairly priced for long term individual investors at all times, taking into account all risk factors.  Indeed, much of the case for long term investment in stocks, is of course based on that exact belief system, and if we say that market professionals are not basing their investment decisions on the long term, then much of that theorized long term protection for small investors disappears right there.

For the practicing professional, this disconnect between the perceptions that determine prices in the short term, and long term theoretical values is interesting, but pretty much business as usual, and may not even seem like a big deal at the moment.  As just one example, consider the hundreds of thousands of market professionals who understood quite well that the market exuberance associated with the tech bubble of recent years was leaving rationality further behind with each year of gains.  Indeed, just about everyone with a degree in finance or accounting had the theoretical knowledge to understand this divergence between the real economy, real corporate profits, cash flow, and market prices. 

Knowing that was fine, but what to do about it was another matter.  The problem is that being theoretically right in the long term doesn’t mean that you will be able to keep your job or your clients this year or next year.  For markets move with market perceptions about what is important, and if current market perceptions don’t include a particular fundamental as being key for pricing, then making a good play on that fundamental won’t necessarily do anything for your career.

Unless, of course – you have a settlement date.  Because having a settlement date changes everything.  A settlement date forces convergence between market perceptions and underlying fundamentals.  It means that if the financial contract is mispriced relative to the underlying asset, you go long one side, short the other, and lock in your arbitrage profits today.  If you are a professional or sophisticated investor with the full range of investment options available to you, this means extraordinary and direct opportunities to profit from this market inefficiency.  If you are a more general investor, then knowing that there is a settlement date means that you know that a convergence will be forced within a time frame, and this advance knowledge can then be invaluable to you.

You might ask:  What is this settlement date associated with the Boomer Effect, and how reliable is it?

The answer would be that the Boomer Effect is a settlement date.  That’s what it is!  Because the Boomer Effect is people and life, and life comes with a settlement date.  Not just the ultimate settlement date, but the many dates before.  We may not like it, but aging is an unstoppable process that will continue for so long as we are each alive.  We know that all of us are each getting older every year, and we also know that over 77 million Baby Boomers are getting older each year. 

We know that the Boomers have been the largest generation of long-term investors in history.  We know that as they age, Peter Pan scenarios aside, they will be retiring, in a reasonably predictable manner.  We know that they will be systematically flipping over, year by year, from buying financial assets, reinvesting all their profits through tax deferred plans, to cashing out financial resources for real goods and services.  We know this unprecedented level of cashing out, over the course of decades, will be happening side by side with unprecedented intergenerational demands for the payment of Social Security and Medicare, or their equivalents in other nations.  We know that all of this will be taking place within a context of fewer workers per adult, as discussed by Bernanke, the GAO, and many others.  We know that this combination of factors must almost certainly lead to a reduction of the consumer spending growth rates that current securities prices are built upon.

While we do not know the exact specifics for each change, we know the big picture will be arriving with the same certainty that we know what our age will be on our next birthday.  Because the big picture is about 77 million people having birthdays and getting older. 

So, we have our underlying asset, which is the overall economy.  We have our futures contract, which is much of the financial markets, particularly stocks.  We have our settlement date that forces the convergence.  For everyone is getting older every year, and the profound economic changes that will be associated with the aging of the Baby Boom are coming on fast.  And we have markets that are not yet pricing changes in the underlying asset into current market levels.

For the professional investor then, every part of the arbitrage is already in place.  The asset, the financial contract, the mispricing between the two, and the settlement date.  Or, more accurately, we have a myriad of arbitrage opportunities, with a diverse range of settlement dates.  Because the retirement of the Baby Boom is an event so large that it will change everything, and it will be arriving piecemeal over decades, meaning succeeding generations of many kinds of arbitrage opportunities.  For the creative player who can use derivative securities in hedge strategies, there is a veritable playground of opportunities available, at least, until everyone else starts doing them.

For the individual investor, or the long term institutional investor, the settlement date inherent within the Boomer Effect means that the times will be a changing.  This is particularly true for investors who are market contrarians or bears, and the professionals who serve them. 

If you want a water-based metaphor for this investment world of ours that is awash in liquidity, then the Boomer Effect is not a tsunami, not a hurricane – it is something more powerful, more inevitable, more predictable, something already happening.  The Boomers are the tide.  A tide has been rising for a generation, pouring more and more savings into the markets.  Meaning a contrarian could have been right about the fundamentals, over and over and over again, and still lost money every time.  Well, that tide is getting ready to shift, the Generation of the Contrarians will be upon us.  A change with profound implications for numerous non-traditional investment strategies.

Unfortunately, there is a misunderstanding associated with when the Boomer Effect is going to start arriving.  If we view the Boomer Effect as a great tsunami or storm, the dramatic way that it is usually presented, then we may look at years like 2010, when the leading edge of Boomers hit 65, or about 2017 when Social Security’s cash flow is projected to go negative, as being the crucial years for investments.  In other words, something very bad will happen in the future, but it is not part of today’s markets.  That is too bad, because as with any arbitrage, the easiest money and opportunities for exceptional returns are on the front end.  When too many people recognize the arbitrage, prices change, and returns can be expected to fall.

Indeed, when we look at this demographic tide that is already shifting, the best years for astute investors just may be 2007 and 2008, possibly extending into 2009.  This timing of 2007 through 2009 being the years of maximum opportunity is true for both long term individual investors pursuing contrarian strategies, and for institutional investors seeking both arbitrage and alpha. 

It is now May of 2007, and this article has been continued in several different ways, with more on the way.  The biggest update is a new 200 page book, The Secret Power Within Your Mortgage (link here), which shows in step by step detail, a historically proven strategy for how homeowners can turn a problem with interest rates and the dollar into their personal gain.

Framed in an arbitrage perspective, it is hard to find any evidence that current bond market pricing takes into account the enormous, budget busting costs of paying for promises extended to Baby Boomers.  We know these promises are real, we know they will be having a profound impact on government budgets as well as the overall economy, and we know this, not risk, but near certain budget catastrophe, is not being priced into 30 year Treasury bonds that currently carry rates that are only about 2% above the current rate of inflation.   This is a fundamental mispricing, which makes it very difficult as investors to buy long-term bonds as a buy and hold strategy. 

So, we turn problem into opportunity by reversing our exposure, and effectively going short the dollar and interest rates through borrowing.  Now our net worth rises with higher interest rates and inflation, and as demonstrated in detail in the book, the higher inflation goes, the more money we make.  The borrowing is long-term, low-cost, tax-advantaged and has a positive skew – that is, the strategy can be locked in for the long-term if interest rates rise for powerful annual benefits, but relatively cheaply exited – or reset at a more advantageous level -- if rates go down.  The strategy is contra-cyclical, and can be paired with real assets to create a “reality hedge”, or used to offset conventional assets such as a 401(K).

For individuals, this book demonstrates in detail how to implement a powerful and historically proven strategy.  For institutions and high net-worth investors, it is an illustration of principles, that can be applied with alternative instruments.  Some supplemental readings can be found in the articles “Inflation Pickpocket:  How Scott Used Inflation To Separate Peter From His Net Worth” (link here), and “The Great Game, Gold Arbitrage & Three Little Pigs” (link here).  Please also note that while gold has its uses and gold will likely perform exceptionally well during some (but not all) of the key stages ahead, precious metals hedges are only one small component of the myriad of arbitrage opportunities that will be presenting themselves over the next decade. 

As for the articles we discussed at the beginning, if you go to the transcript, you will find links for each.  (Bernanke here, Walker's link expired, but similar speeches can be easily found with a search engine).  Several other arbitrage oriented articles will be coming out over the next several months.  Be sure to get a free subscription, available at the website, if you would like to be notified when the next article does come out. 

In the meantime, you can’t use the Boomer Effect, if you don’t understand the Boomer Effect.  The-Great-Retirement-Experiment.com is a unique, holistic and people-based look at the many intertwined and profound changes that are coming up fast for our society.  The first book, Contracts With Our Children, is the core of the site and what puts everything in context, you can read more about it here.  The first two free pamphlets are good supplemental educational resources, with over a hundred pages of information between them.  You are encouraged to download them and pass them along.

Thanks for listening, and my best wishes for your personal long-term future.

©2006, 2007 Daniel R. Amerman, CFA

The Great Retirement Experiment is a series of pamphlets and books that are dedicated to taking a holistic and people-based look at the long term future of Boomer finances. Holistic meaning that the retirement investment sale experiment, the pension experiment, the consumer spending experiment, the Social Security experiment, and the Medicare experiment are all considered together, with the interconnections between these individually unprecedented experiments combining to form The Great Retirement Experiment.  People-based in that the future is explored not based upon past investment returns, but by looking to the situations, motivations and self-interests of the buyers of the Boomers' investments, the younger generations who will be paying for all of the experiments.  Call it Adam Smith meets the Boomer Bust.

This website, including the pamphlets, books and videos, contains the ideas and opinions of the author.  It is a conceptual exploration of general economic principles, and how people may – or may not – interact in the future.  As with any discussion of the future, there cannot be any absolute certainty.  What this website does not contain is specific investment, legal or any other form of professional advice.  If specific advice is needed, it should be sought from an appropriate professional.  Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.