How Far Ahead Does the Stock Market Look? Five Years

The young and brilliant Stefano della Vigna (whom I never see because he's a fifth-floor person and I'm a sixth floor person) has what looks to me like a serious finance research hit--extra bases and RBIs:

Looking Long Term? Get Your Glasses - New York Times: [F]ew investors can focus on events more than five years ahead, even when those events are very predictable and almost certainly will have a big impact on a company's earnings. The study, 'Attention, Demographics and the Stock Market,' was conducted by Stefano della Vigna, an assistant professor of economics at the University of California at Berkeley, and Joshua M. Pollet, an assistant professor of finance at the University of Illinois at Urbana-Champaign. A copy is at http://www.nber.org/papers/w11211

The study is attracting much interest because researchers for many years couldn't figure out how to disentangle the attention span of investors from other factors that could also explain their behaviors. How, for example, to interpret why investors are unimpressed with a company's announcement of a new research and development effort that it says will lead to higher profits in 10 years?.... Della Vigna and Professor Pollet solved this problem by focusing on industries whose profitability depends heavily on the age distribution of the population. Bicycle makers are a good example... people in their late 30's or early 40's bought bicycles at nearly twice the rate of the overall population, in large part because they were buying them for their children. By contrast, consumers under 27 or over 55 bought bicycles at rates far below the national average.

The professors focused on two dozen age-sensitive industries - from toy and beer makers to nursing home operators and funeral homes - from January 1935 through December 2003. For each industry, they built a model of the year-by-year changes in demand caused by shifts in the age distribution of the population. On average, they found that when their model predicted a one percentage point increase in demand for an industry's goods or services, its profits that year were 5 to 10 percent higher.

If investors conformed to the completely rational, fully informed ideal described in an economics textbook, they would immediately take into account the long-term effects of a changing population. The stock prices of age-sensitive companies would thus be bid up or down soon after major changes in the country's birth rate, for example, even if the changes' effect on companies' earnings was not felt for several decades.

The professors found, however, that virtually no investors conformed to this ideal. Instead, the study found that the price of a stock began to change only about five years before shifts in age distribution started to have big effects on that company's earnings.... [O]ver the 68 years studied, competition did not eliminate the extra profitability in age-sensitive industries. One reason, the professors suspect, is the entry barriers to at least some of them.

Comments

[Macneil]

Sounds like a piece of the equity premium puzzle to me!

[dsquared]

The answer is of course that all manner of things can happen in this crazy old world and that the prior distribution five years out is as close to flat as makes no odds. Imagine what a muppet you would have felt if you'd looked at the demographics of Western Europe in 1987 and said to yourself "better invest money on the basis that there will be no massive influx of cheap labour here".

[anne]

DSquared

Please explain your interesting hint a little more. Are you referring to American immigration or European immigration, and in what sense? Stock investment? Real estate?

[spencer]

When I read the article I saw nothing to suggest that the authors checked to see if the improved market the firms were facing was not already included in the analysts earnings forecast. Since analysts tend to depend heavily on firm management for such 5 year forecast I find it difficult to accept that the improvement was not in the analysts 5 year earnings forecast.

Of course this does not negate the possibility that the market is only looking 2 years out.

[John Emerson]

The cranky right-wing environmentalist decribed a interdisciplinary conference which collapsed when everyone there found out that five years was long-term for economists, while 100 years was short-term for environmentalists.

[John Emerson]

"cranky right-wing environmentalist Garrett Harden"

[knut wicksell]

Maybe this is why Warren Buffett is the second richest man in the world. He looks out 20 years.

[Barry]

I second dsquared - especially as the primary changes themselves can cause counter-changes (e.g., increased demand for programmers leads to more programmers and higher salaries, which leads to making the effort to use offshore labor, combined with a glut of programmers drawn in by the higher salaries).

[sm]

Brad, walk down one floor and say hello!

[anne]

Well, if the difficulty is projecting for 5 years then the difficulty can be readily simplified. When information technology stocks were doubling in value in 1999, while medical technology stocks were flat though valuations on health care issues were far more favorable, there was a simple choice for an investor who had chosen not to try to freely trade markets.

The problem can be simplified even further. Why decide whether Pfizer or Roche is a preferred technology holding when a health care index can be bought or the Vanguard Health Care Fund?

So too, I do not find energy or public utility issues to have been difficult choices in 2000. Nor do I find even long term bonds to have been a difficult choice in 2000. Always the matter of choice can be simplified by indexing.

[anne]

Looking at demographic issues now, we can be reasonably confident that we will be aging through the decade, and there are several investments to consider as a result, with a few attractive on current valuation. Also, we can be confident there will be increasing competition from the explosively grown populations of China and India and likely Brazil. Again, immigration has changed American landscapes significantly this last generation and looking about Los Angeles or New York or Chicago there should be opportunities continually suggested.

[wcw]

I loved that study, and probably for the opposite
reason others did. See, I thought the most that
public markets were capable of looking forward
was about eighteen months (for such has been my
experience trading mostly since the early '90s).

That there is any evidence at all that markets
can look forward a full sixty months is greatly
enheartening to me. Perhaps there is hope for
us blinkered humans after all.

[dsquared]

I was referring to the fall of communism and the reunification of Germany; events that absolutely nobody was predicting as of 1987. The natural thing to have done in 1987 on a twenty year view would have been to massively overweight Germany and massively underweight the UK and Ireland, which were at that time referred to as "the sick men of Europe".

[anne]

Thank you, DSquared. Right you are, there is need for considerable considerable humility in projection :)