Baby Boomers Versus Greater Fools

• The stock market has made many baby boomers wealthy, but a crash could make them poor. Now is not the time to risk lifetime savings.
• Stocks have earned a whopping 6% annual alpha over the past 15 years. Young investors have seen this extraordinary growth; they haven’t seen a big crash.
• Human behavior, rather than corporate success, has been the main reason for the stock market's 15-year stratospheric rise. Behaviors change.
• Because baby boomers have the most to lose, they need to be smarter than the greater fools who repeatedly bid up stock prices to new all-time highs.

I once attended a meeting that included Harry Markowitz, father of MPT. The meeting set return and risk asset class expectations for the purpose of establishing an efficient frontier forecast. To initiate the discussion, the investment company showed the committee a risk-return X-Y graph of its expectations. Harry got up and drew an eyeballed line of best fit through the dots and directed a conversation to justify the assets that fell above (why the expected premium) and those that fell below (why the  expected underperformance).

That line represents roughly equal return/risk Sharpe ratios, so equal returns per unit of risk. Distances above the line are forecasts of alpha, and those below are forecasted to return below average for their risk (negative alpha).

We all know that the past 15 years have been extraordinary for US stocks. It’s the longest bull market ever. The following graph shows how good. The 15-year alpha is a whopping 6%/year!! Large US stocks have returned 6% more on average every year than the Capital Market Line of constant return per risk

Over this 15-year period, the average return per unit of risk was .75%. Large US stocks earned  1% per unit of risk – a 15% per year return for a 15 standard deviation. That’s a whopping 33% premium.
 

Why?

The question isn’t did large US stocks outperform. It’s why did they outperform for so long and by so much. Here’s a way to break down the answer to that question. The return formula is as follows:

 Return = Dividend Yield + (1 + Earnings Growth) X (1 + P/E expansion/contraction) – 1

 Here are the components of return for large US stocks

Most (52%) of the extraordinary return is explained by P/E Expansion, which is the human behavior factor. Investors have been willing to pay increasing prices over time per dollar of  corporate earnings, with P/Es increasing 8% per year to the current 35, from 12 at the beginning of the period in 2009.

Greed is the answer to the question. The other human factor is fear. Fear will kick in sometime. Stock markets crash. They usually do every 3 years, so this 15 years is a big exception. The contraction is 12 years overdue.

22 Reasons for the Next Crash of ‘29

In addition to an overheated stock market, there are many more reasons to expect a crash that are outlined in this article. Please read it and watch the video that is presented in the first paragraph. The 2020s are similar to the Roaring Twenties of a hundred years ago.

Morningstar says half of our current retirees will run out of money. A crash increases that number substantially. That’s not just their problem. It’s society’s problem. How will we care for our indigent elderly when social programs like Social Security and Medicare are already going broke? Baby boomers are not fooled; they’re scared. The Beatles recorded “When I’m 64” in 1966, 58 years ago – which was “many years from now” back then: “Will you still need me, will you still feed me when I’m 64?” Today is the Tomorrow of Yesterday.
 

Conclusion

It’s been an extraordinarily great 15 years for large US stocks. Can the party continue? History tells us that something will give and there’s a name for its end. It’s called a Minsky Moment, which is  a sudden and catastrophic collapse of asset prices named after economist Hyman Minsky.  If it can’t go on forever, it will end.

I know you will say that I’m forecasting a crash and that no one can do that, and you’ll disagree, arguing for “staying the course.” Human behavior is the reason that stock prices are so high. We have agreed to pay very high prices, relying on the “greater fool” who will pay even higher prices.

We will run out of greater fools. No one knows when, but we suspect the supply is limited. Baby boomers need to be smarter than greater fools.

Baby boomers are in the greatest jeopardy because most of them are in the Retirement Risk Zone when losses can ruin the rest of life due to Sequence of Return Risk. They likely won’t have time to recover from the next crash. Their loss is also their heirs’ loss. There’s $70 trillion in play.

More By This Author:

Baby Boomers Better Get Out Of The Stock Market Now
Large Cap US Stocks Continue Their Stratospheric Rise In 2024. It’s The Roaring 20s – Again.
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