The U.S. equities by all standards and measures are not dear: both the supply side in terms of sustainable ROEs and the demand side in terms of savings, leverage and inflation shocks are supportive of the current pricing. It is, however, hard to ignore the potential impact of demographics.
A number of years ago the first place we looked to try and explain the historical levels of equity risk premium was demographics. The choice seemed natural at the time: the greater the proportion of older people, the greater the risk aversion and preference for fixed income investments. Despite months of empirical work, however, we failed to find any reliable relationship between the various demographic factors and equity risk premia. LINKS then went on to base the ERP studies on the factors that did exhibit strong empirical relevance: savings rate, leverage and inflation surprises.
As it happens, we did not rid ourselves of the need to think about demographics. As summer of 2015 approaches and the S&P 500 has added a whopping 140% since the low level in 2008 (Figure 1), the question of whether the valuations have become unsustainably high still depends on our understanding of demographics. More specifically, it depends on the elusive link between aging and the savings rate. After all, historically low levels of volatility are yet another reminder of the danger of complacency: the degree of integration of the pro-cyclical nature of volatility with the investment processes of principal investors today is even greater than in 2008.
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