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Newsletter July 8, 2006 Take the Plunge Market & Sector Review Demographics & the Stock Market Largest Changes This Week This Week's Economic Reports Take the Plunge Most seasoned traders' I know do not trade all day, every day. Market conditions change and if your methods are not in step with market conditions, you must step aside until market conditions change. Trading has two phases: first - observation and study then - active participation. For the beginner or for one in a slump the active participation phase can become a scary experience. Trading outcomes are never certain. In fact most amateur online investors overtrade. Why? For the most part they are way to optimistic therefore they put on a trade even if it has a poor chance of success. To become actively involved you must first examine your thinking strategies and perhaps change them. In a sense it's like jumping head first into an ice cold swimming pool. Why don't you just take the plunge? Obviously because you know the water is ice cold and it will be a shock to your system. If you are hesitant about putting on trades, it's because you're afraid. You're afraid to lose. Having a definitive strategy, that you are attempting to implement, should enable you to muster the gumption required, to take the plunge. Try and remember some sage advice from seasoned traders: Expect to lose. Losing trades should be a part of the plan you are implementing, and if that is the case, then you will feel like other winning traders who take losses in stride. It is easy to think that if I take a loss it means my plan and I are failures. A loss is nothing more than feedback. It means nothing about you. Say to yourself I'm not going to have unrealistically high expectations, no matter what happens I'll draw the conclusion that I have become a seasoned trader. If I lose it will be tuition money, spent on learning to master the markets. Part of your plan and vital for your survival; is to control risk. Begin by making small trades and waiting for high probability setups. Remember there are no guarantees it's all about probability. If you do not understand and manage risk you will surely, sooner or later, blow out your account. Therefore you must risk relatively little, in terms of your account size, on a single trade or even set of trades. Still afraid to take the plunge, consider easing into it by making extremely small practice trades. Note I did not say paper trades but actual very small position sizes. No matter what happens it will be worth the cost and help get your feet wet. It will take the mystery out of the process. We all have a natural inclination to believe a dreaded event to be more hurtful than it actually is. We exaggerate the potential harm. However, once we jump into the activity, we see that it isn't so bad. Our worst fears are usually never realized. Once you make a series of small trades successfully, you can increase your position size until you reach a position size consistent with your account size. The trick is to take gradual steps. It's like building up physical stamina. Don't try to do too much all at once. Work up to it. Taking the plunge into trading actively can be scary. If you examine the assumptions underlying your fear of losses, and then make actual trades to break out of your self-imposed psychological shell, you can master the markets and become a seasoned, winning trader. Market & Sector Review Demographics & the Stock Market The most profitable way to invest in the stock market for the average person is to invest in harmony with the primary trend, easy to say, sometimes difficult to do. There are no certainties; no one knows what the future holds. A true statement, however, there is one long-term fundamental which can produce an excellent and predictable future; demographics. If you are aware of age-sensitive group fluctuations you can readily see demand changes for certain sectors, for example; toys, bicycles, beer, life insurance and nursing homes. These demand changes become predictable once a specific cohort is born. As an example; assume that a large group is born in 2006. This large group will increase the demand for school buses in 2012 and beyond; simple. If the school bus industry is not perfectly competitive, the companies in the industry will enjoy an abnormal increase in profits in 2012. An abnormal increase in profits will translate into an abnormal increase in share prices as well. If you can spot changing demographics then you can predict profitability by industry. Forecasted demand changes five to ten years in the future predict annual industry stock returns. One additional percentage point of annualized demand growth due to demographics in effect predicts a five to ten percentage point increase in annual abnormal industry stock returns. Interestingly forecasted demand changes over shorter time periods do not accurately predict stock returns. Think five to ten years hence when looking at demographic shifts. Different goods have distinctive age profiles of consumption and therefore predictable changes in the age distribution will produce predictable shifts in demand for various goods. Demand shifts produce predictable changes in profitability for industries that are not perfectly competitive, especially those industries with a high entrance cost. While long time readers have heard me often talk of cyclical and secular trends in the overall market, become aware of another secular trend that is not very difficult to recognize; the super secular trend of aging demographics around the world. We have all heard it from the media, but how deep and pervasive is this demographic shift? A good knowledge of this trend is very important. The chart below is the age distribution of the U.S. population as of the 2000 census; add 6 years to each age distribution for approximate current data. The United States as well as most of the developed countries around the world - are getting older quickly. Within 30 years the percent of the U.S. population over 65 years of age is projected to double, making that group more than a quarter of the entire population. While baby boomers account for most of this increase. The rest can be explained by a dramatic increase in life spans. Between 2000 and 2050, the population of 75 to 84 year olds is expected to double and those 85 and over could increase by 300 percent. Centenarians, which were extremely rare a generation ago, are projected to grow as much as tenfold. At the same time this group expands, the working age population will shrink. This can be seen in the ratio of workers to retirees. In 1950, there were 16.5 workers per retiree. In 2000, this ratio fell to 3.4. In 25 years, the ratio is expected to be just 2 workers for each retiree. And not just the United States… It may seem like I'm on a path to discuss social security, government obligations, and taxation, however the real intent of this letter is: What will these demographic changes mean for financial markets and of course certain sectors of the markets? In their paper Demographics and Capital Market Returns , money mangers Rob Arnott and Anne Casscells say that "the simple mechanisms of supply and demand should lower the return on assets: A larger group of retirees than ever before will be selling to a proportionately smaller working population than ever before." A contrary point of view that definitely calls into question the above doomsday scenario is presented by James Poterba, an economics professor at the Massachusetts Institute of Technology. He argues that retirees hold onto a majority of their assets in retirement rather then selling them. In his paper: "Population Aging and Financial Markets", Poterba states that the 65 to 85 age group will hold a majority of financial assets. Using the Fed's Surveys of Consumer Finances, he estimates that the share of net financial assets (consumer debt minus gross financial assets) held by households over 65 will grow from 31 percent of the total to 37 percent in 2020. By 2040, this group will hold 44 percent of net financial assets. While this debate will continue for years to come a few things are certain. Many retirees seem to prefer bocce balls to business suits. They're also active consumers of healthcare services and cruise ships. Can anticipating these trends offer extra return? Data from the U.S. Bureau of Labor's 2003 expenditure survey suggests that spending in almost every category actually declines with age. The only category in which spending rises with age, as you might expect is health care. The question one must ask is will the boomer generation be different? Comprising roughly 77 million people born between 1946 and 1964 the boomers have been a generation of trend setters establishing new movements and styles simply by virtue of their size. They have been a generation who has had to compete against one another for jobs, thus leading them to be a mobile population. The combination of their mobility, career goals, education, and delayed families has displaced them from traditional patterns of social networks and extended families. They have always considered themselves to be young and will probably continue in that tradition. They are the group who altered American consumption habits by popularizing toys and computers among adults. Surely as boomers age, they will be the force that changes the way Americans view old age. For example, it has only been since 1980 that fifty per cent of Americans over age 55 have had a high school diploma. Prior to that, the "older generation" had generally been a group considered to have little formal education. On the other hand, eighty-seven per cent of the boomers have their high school diploma, and one out of four baby boomers has a college degree, with over half of the boomers having some college experience. Boomers spend more of their household income on items such as books, entertainment, cosmetics, new vehicles, restaurant meals, and non business computers than any other age group in America. Of course by the sheer size of this group, their spending is likely to be greater than other age groups. However, as boomers move into their senior years, will spending on these items continue, or will their spending be on other items? What new trends will older boomers set? Will they taper their spending habits to accommodate upcoming retirement? The baby boomers have always been the trend setting group in American society. They have been observed from the cradle, through their teen years, and into adulthood. They will inevitably change the way America views old age as they dominate the country's population in this century. I am reminded of the story of a friend a few years back (late 2003) whose teenage son told him dad; Apple is hot! Unfortunately this friend did not pay close enough attention, did not investigate it further, and never purchased a share of AAPL, much to his chagrin. In addition to the obvious health care sector and thanks to some of the research for this newsletter, the cruise ship industry, begin to think of how this generation's spending habits will change. If you are a member of the boomer generation begin to think of your retirement years and where your money will be spent. If you are younger talk to your parents and their friends attempting to discern what is hot to this huge generation. What new products and services will they gobble up like the younger generations gobbled up ipods. Will the companies providing these products and/or services be large coglomerate's, or perhaps smaller potentially dynamic growth company's? Keep in the back of your mind this dynamic demographic shift taking place, you just may spot the ipod for seniors that will reward you as the ipod rewarded investors over the last few years. A few sources of information for this newsletter: Attention, Demographics, and the Stock Market - Stefano DellaVigna UC Berkeley and Joshua M. Pollet UI Urbana-Champaign The Baby Boom and the Stock Market Boom - Kyung-Mook Lim and David N. Weil Demographics and the Financial Markets - William Hester, CFA Largest Changes This Week This Week's Economic Reports Have A Great Week! Bill Disclaimer: Trading in securities, of any type, may not be suitable for all individuals. The contents of this newsletter are not a solicitation to buy or sell securities. The opinions expressed are solely that of the author. You must do your own research, contact your own financial advisor for suitability of any investments. Data gathered is from sources believed to be reliable, but NO guarantee as to their accuracy is made.