Tactical Execution

Back in 2000, I read a book called “The Roaring 2000s” by Harry Dent Jr. It’s a brilliant book based on the premise that people go through predictable spending cycles during their lives that peak when their 46 years old. In other words, the average American reaches their PEAK spending year when they’re 46. That’s when they earn a good living and they’re probably still paying their mortgage, maybe a car or two and supporting the lifestyles of a growing family – maybe even some college expenses.

So there’s this curve of spending that increases as people grow older and it peaks at 46 years of age and then it slowly drops off again. Well, on top of that, we’ve got an incredible concentration of people who are all roughly the same age – the Baby Boomers. That’s defined as all the babies that were born between 1946 and 1964 – almost 76 million Americans. So you can use that birth data to project what might happen to the greater economy as all those people go through the spending cycle. Keep in mind that two thirds of GDP is made up of consumer spending. So just doing the straight math, we should expect a surge in consumer spending between 1992 and 2010 – that’s just 46 years added to 1946 and 1964 respectively.

Well, the US Census Bureau provides extensive data measuring all this stuff and its all free public information. Birth data, mortality statistics, immigration, income, spending – everything. So I started building a mathematical model back in 2001 that takes Harry Dent’s logic to a much more sophisticated level. The whole thing is built on a dynamic population platform that uses birth data, immigration statistics and the mortality curve to calculate the population at every single age and tracts all these people mathematically as they grow older.

The model then projects income and spending data (which is also tracked by age, by the way) on the population platform to determine how much money is being added to the pool of investment capital and how much is being taken away on a year-by-year basis. As Harry Dent suggested, people go through different stages of their lives and their income, spending and savings behavior changes dramatically from one stage to another.

Here’s how it breaks down. And this stuff is all based on publicly available US Census Bureau information. The AVERAGE person spends MORE than they make between the age of 15 and 26, resulting in NEGATIVE savings. They’re spending MORE than they earn. Somebody’s subsidizing these young people, right? I mean, the extra money has to come from somewhere, probably their parents. But it goes beyond that. This extra money isn’t just sitting in a shoe box somewhere. It’s being pulled OUT of somebody’s bank account. So again, people between 15 and 26 have negative savings and that money, one way or another, is being taken out of various bank accounts.

Between the ages of 27 and 62, the AVERAGE person makes MORE than they spend. In fact, both go up. They MAKE more money AND they SPEND more money. But their earnings grow faster than their spending and they end up with POSITIVE savings between the ages of 27 and 62. And as Harry Dent pointed out, the peak spending does indeed take place when people are about 46 or 47 years old. Anyway, the important thing is that their savings are positive during these middle years so that money is being DEPOSITED into bank accounts, one way or another.

And from 63 onwards, the average person once again has NEGATIVE savings so their spending MORE than they make. And again, that financial shortfall is coming out of bank accounts one way or another – probably retirement accounts. So you have this progression during life: negative savings in the early years, positive savings during the middle years and negative savings again during the twilight years. The way it works out, it’s these middle-aged people who end up balancing the negative savings of the young and the old.

Since we know exactly how many people are alive at every single age based on my population platform, we can calculate whether or not the total savings of these middle-aged people is more or less than the money being taken OUT by the other two groups. If it’s MORE, the total pool of investment capital increases – there’s MORE money available – and interest rates go down as a result. If it’s LESS, the pool of investment capital shrinks and interest rates go up. Remember, mortgage rates are the result of the supply and demand for money. If there’s MORE money, you’d have to pay less for it. If there’s LESS money, interest rates would get bid up and you’d have to pay MORE to borrow.

Now think back to the late 1970s and early 1980s – in fact, let’s take 1979. Well, in 1979, the Baby Boomers were between 15 and 33 years old. MOST of them were in a period of negative savings, and they HAD been in that stage for a number of years already. So what would you expect in terms of interest rates at that time? Well, you’d expect them to be high, right? I mean, there must have been almost NO money out there. All these people had been taking money out of their bank accounts for years. The pool of investment capital out there must have been SERIOUSLY depleted.

Well, as we all know, interest rates were indeed very high in the late 1970s and early 1980s. We also know that interest rates have basically been dropping ever since. Yes, of course there were ups and downs along the way but the overall trend was down UNTIL 2003, and that’s when it started going up again. So think about it. It makes sense, doesn’t it? The Baby Boomers have been shoveling money into their savings accounts for the past 20 years and low and behold, interest rates have been dropping.

Of course, it wasn’t always a smooth ride and the money sometimes shifted from one place to another. For example, people tend to invest in stocks when they’re a bit younger and then slowly move money over to bonds in their later years so it made sense that the stock market would peak slightly BEFORE the bond and housing markets. And when the stock market crashed in 2000 and 2001, people pulled their money out quickly and moved it all into real estate and the bond markets so interest rates dropped quickly while house prices soared. But it’s all part of the same phenomena.

The Baby Boomers have been savings money for years. All that money has been accumulating in various savings vehicles all across the country, and across the world by the way. Although my model maps only the American population, the entire western world had a baby boom after World War II. So the whole thing has been magnified because there were similar population bubbles in Europe. China and India have also been contributing to the situation by accumulating wealth and that’s filtered into the global financial system. And all that money has inflated prices for a variety of commodities and lowered interest rates for borrowing.

So what happens next? Well, the Baby Boomers start retiring in 2011 and it continues all the way through 2029. And they’ll all live for a long time too. The mortality curve is getting longer every year. Frankly, the longer they live, the worse the effect will be. Their living expenses have to come from somewhere and you can bet they’ll stop at nothing to maintain a decent lifestyle during their retirement. So unfortunately, we’ve got some difficult years ahead of us. In fact, I recently read that over ½ the Fortune 500 companies have under-funded pension plans. So these companies will probably start having some major financial problems about 10 years from now.

I’m not trying to present a dooms day scenario but we all have to realize we’ve just finished one of the largest financial booms the world will ever see. It’s unlikely there will ever be such a disproportionate concentration of people in a single age category. As the world population gets bigger, a concentration like that becomes harder and harder to achieve. And it’s that disproportionate concentration that caused the economic pain during the 1970s and the severe recession of 1981 and it’s also what caused the boom we’ve had ever since. Unfortunately, it’s also what will cause the difficult times ahead.

So what does it all look like, exactly. Well, my model calculates modest appreciation in the real estate market up to about 2009. After that, it calculates a largely sideways market for the following 10 years and then some reasonable appreciation rates return around 2026. During that time, interest rates will rise progressively and peak out in 2027, roughly four percentage points higher than they were in 2003 (30-year fixed). So if 30-year fixed mortgages bottomed out at 5.5% for a best-case scenario, I’d expect them to peak around 9.5% in 2027.

At that point, the oldest Baby Boomers will be 81 years old and the youngest will be 63. Believe it or not, things actually start getting better at that time because the Echo Baby Boomers (that’s the children of the Baby Boomers, a less-concentrated population bubble) will be entering their positive savings years about that time, offsetting the cash drain from their surviving parents.

We all recently heard President Bush talking about Social Security reform. In all his speeches, he always gave grim statistics about the year 2026. He always said “by the year 2026, we’ll be …” blah, blah, blah. Why do you think he chose that year? Why do you think he chose 2026? Look, my model isn’t unique. There are plenty of Economists who have similar models calculating into the future based on expected population growth and well established spending and savings patterns. Bush was trying to convince us that Social Security is on a collision course and he chose the absolute worst year to demonstrate his point. That’s as bad as it gets! 2026. That’s it! After that, things slowly improve again.

Now, don’t think I’m suggesting Social Security is in good shape. Absolutely not. There’s no question in my mind that Social Security is heading for a complete disaster and I don’t think it’ll take ‘til 2026 to get there. I think the melt down will begin around 2018 or so. Write it down. We’ll see what happens. Time will tell, as it always does.

Listen. I’m absolutely not preaching my predictions as Gospel. I’m one person with one opinion. I’m just a Mortgage Banker with a somewhat obsessive passion for demographics and macro economics. You probably have your own opinions and that’s great. But you need to know that I have very specific reasons to give the advice I give and to recommend the loan programs I suggest. When my clients ask for my opinion, it’s not just hear-say. It’s not just some editorial content regurgitated from last night’s news broadcast. I give my opinion based on a mathematical model I believe in. I know exactly how it calculates. I know WHAT it calculates. And I’ll stand by it until its proven wrong. So far, it’s been dead on and I have no reason to believe its future predictions will be any less accurate.

A couple last minute things. First of all, the model predicts long-range trends. Historically, there have been extended periods of time when actual interest rates were higher or lower than my model predicted. There’s no question that other factors affect interest rates and those other factors can influence the market in the future the same way they have in the past. Nevertheless, the overall trends have been perfect and that’s what I’m trying to share with you.

Secondly, I still believe real estate is a great investment, particularly because of the leverage it allows. When you put 5% down on a house, you’re leveraging your money 20 to 1. When you invest in the stock market using MARGIN, everybody freaks out saying it’s too risky. Well, that’s only 2 to 1. In real estate, the leverage is far greater and nobody bats an eye. And that leverage along with the tax advantages of homeownership combine to make real estate a very attractive investment in all but the worst possible market conditions. Just don’t expect the 15% or 20% annual appreciation rates we’ve seen over the past few years, that’s all. Future rates of appreciation will be much, much lower.