longer be appropriate in today’s market. If the real risk-free rate of in-
terest on long-term TIPS bonds is 2 percent, then a 3 percent equity pre-
mium will yield a 5 percent real return on equities, equivalent to a
price-to-earnings ratio of 20. If the equity premium shrinks to 2 percent,
then the price-to-earnings ratio can rise to 25 to yield a 4 percent real,
forward-looking return on equities. If the real risk-free rate rises to 3
percent, the real return on equities will be 5 percent with a 2 percent risk
premium, implying a P-E ratio of 20. Therefore, if inflation stays low,
the tax policy remains favorable for equities, and the business cycle re-
mains muted, one can justify price-to-earnings ratios in the low 20s for
the equity market.THE AGE WAVE
Inflation, tax policy, macroeconomic stability, and the drop in transac-
tions costs are important factors influencing the valuation of equities.
But looking into the future, there is one factor that is apt to be even more
important: the age wave.
The reality is that the United States and the rest of the developed
world stand at a precipice. Over the next two decades, nearly a quarter
billionAmericans, Europeans, and Japanese—members of the prosper-
ous baby-boom generation that was born following World War II—will
leave the labor force. Many are expecting a long and comfortable retire-
ment by relying on government and private pension plans as well as tax-
supported medical services.
But unless we can exploit the dramatic demographic and econom-
ics changes that lie before us, our future may be much poorer. Instead of
stepping into an easy retirement, many retirees will tumble into a retire-
ment marked by bankrupt government social programs and declining
asset values that will quickly deplete their cherished nest eggs.
This forecast is not based on an unpredictable future but on events
that have already transpired. Aside from immigration, we know almost
exactly how many people over the next 20 years are going to reach the
working age of 20 and the retirement age of 65. “Demography,” as the
great management sage Peter Drucker once remarked, “is the future that
has already happened.”^20CHAPTER 8 The Impact of Economic Growth on Market Valuation and the Coming Age Wave 133
(^20) This quote was the title of Peter F. Drucker’s Harvard Business Review(HBR) article published in
HBR’s September 1997 edition marking its seventy-fifth anniversary year. Drucker’s article was
part of the journal segment “Looking Ahead: Implications of the Present.”