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We’ll give you a hint: it isn’t jobs, student debt or housing.

A comprehensive analysis of the market requires a holistic view. Understanding where we are and where we are going, particularly during transitions, means looking beneath the surface of recent market performance, corporate results or news headlines.

Let’s elaborate demographics. You’ve probably read about the aging of society and declining worker-to-retiree ratios, and the likely impact on deficits, debt, inflation and asset markets. Here, let’s look at the other end of the spectrum– household formation, the current state of the Millennial generation and the large impact that subtle cultural changes can have on economic and market outcomes.

Although the above infographic is a few years old, it does a good job of categorizing the major American generational groups. The Millennials are now in their 20s and 30s and their behavior as a group has profound consequences for how economic growth will play out in the years ahead and how the shifting nature of those economic decisions will affect markets going forward.

The Millennials are sometimes called the Peter Pan generation because of their tendency to delay some of the traditional rites of passage into adulthood like moving out, getting married and/or having children. This, along with other cultural factors, has dramatically altered the make-up of U.S. households over the last several decades with married couples living with children now comprising less than 20 percent of all U.S. households, down from more than 40 percent in 1970.

However, it is not just the make-up of U.S. households that is dramatically changing; it is also the number of household formations. Household formation involves a complicated series of decisions including, for example, whether to move out of, or back into, a parent’s home, whether to live alone or with roommates, and whether to get married to or form a partnership with another individual. The chart below shows the number of new household formations since 1947, and the latest data for 2013 shows a decline in the number of households formed for the first time in the post-war era. When we smooth the data (dotted line) there is an unmistakable downward trend over time.

Household formations are very important to economic growth for several reasons. The most obvious is that increasing numbers of households translates into demand for new housing units, whether single-family homes, condominiums or apartments. Demand for housing units drives capital spending and employment in several key sectors of the economy. However household formation also drives other types of consumer spending vital to the economy, from durable goods, such as washing machines and refrigerators to retail merchandise, such as furniture and home goods to services, such as utilities, telecommunications.

The decisions that impact household formation are made as a result of numerous cultural and economic factors. For example, Millennials are more ethnically diverse than previous generations, with the correspondingly different attitudes towards multi-generational households.

Additionally, Millennials’ attitudes toward the traditional notions of the American Dream are different from generations before them. In general, they are much more likely to prefer living alone and in urban settings until much later in life. Today, over 30 percent of households are comprised of individuals living alone versus just 16 percent in 1970.

Yet, despite these strong cultural factors, it is the economic factors that are likely driving the significant reduction in household formation in the United States. These economic factors begin with employment and incomes—having a job that pays enough to allow one to establish his or her own residence.

As the blue line in the chart below demonstrates, those under age 35 have the lowest level of participation in the workforce in at least 35 years. As the red line demonstrates, the group also has much lower levels of employment than they have historically.

Not only do more Millennials have fewer jobs than previous generations in the peak household formation years, but even if they do have jobs, they are more likely to be lower paying than in previous generations.

As a group, the young adults in our society who would otherwise be in their peak years for household formation are making no more on an inflation-adjusted basis, and often less, than they have in almost 50 years. Since 2000, the inflation-adjusted income of these young cohorts has fallen steadily. This should be shocking to those who believe in the importance of economic opportunity for a society’s progress.

As always, the challenge is not just understanding where we’ve been, but objectively analyzing where we are likely heading. In other words, are the factors that have reduced employment and driven declines in real incomes for 20-30 year olds, thereby dramatically slowing household formations and with it true sustainable economic progress temporary or here to stay?

Some would argue, for example, that the huge increase in those attending colleges will be a net benefit to the Millennials as those who attend some, or graduate from, college tend to earn more money. This line of thinking may even suggest the commensurate surge in student loan debt represents “a good investment” made by the Millennials, which will enhance future earnings power. While on an individual basis this may be true in many cases, on an economy-wide level it may not be. For example, structural changes in the economy are dramatically altering the value of certain types of degrees that previously resulted in good paying jobs. Those jobs have since been replaced or reduced by global competition, automation or other advancements.

At the same time, the proliferation of the accreditation of, and attendance at, four-year colleges has arguably reduced the quality and value of a degree, especially as a college degree has become a less scarce good. In microeconomic terms, the supply of college graduates has gone up while the demand for their skills may be declining, which leads to a decline in the value of a college degree in general.

As evidence, a study by the Institute for College Access and Success found that over 37 percent of recent graduates are working in jobs that do not require a degree. While the unemployment rate among young college graduates is around 7.7 percent, a broader measure including those who are working fewer hours than they wanted, were not working but still looking for work, or had given up looking for work, stood at 18.3 percent.

The details of the surge in student loan debt are staggering, disturbing, and somewhat beyond the scope of this piece.

The basic fact is that among 2012 graduates at public colleges nationwide, 66 percent had loans and owed an average of $25,500; at nonprofit colleges, 75 percent had loans and owed an average of $32,300; while at for-profit colleges, 88 percent had loans and owed an average of $39,950. This says nothing of the students who take out loans to attend college and never graduate.

This mountain of student debt ensures a larger share of future Millennial’s income will go to debt service, thereby impeding future spending on housing, retail sales and pretty much everything else. Furthermore, this is coming at a time when the cost of housing and vehicles alone is over 50 percent of after-tax income for those under 35.

This is another reason that while a greater percentage of Millennials are attending college than any other generation before it. Millennials have earned the moniker the Boomerang generation for their tendency to move back in with their parents after college.

Ground Zero: The Housing Market
The bottom line is that sorry employment prospects for the vast majority of Millennials are preventing an important swath of society from forming households while real incomes are not keeping up with real house prices. As we covered in our July 2013 piece, “Real Estate Echo Bubble,” low supply coupled with low rates and high demand from institutional investors has rapidly driven prices up, further reducing affordability and demand from many buyers. This is especially true for the Millennials, many of whom are would-be first-time homebuyers.

In data from a recent study from the National Association of Realtors®, it becomes apparent that the housing market is ground zero of the deceleration in Millennial household formation.

First-time buyers accounted for 26 percent of home purchases in January 2014. This is down from 27 percent in December and 30 percent a year ago, making it the lowest level for first-time buyers since October 2008. This group of buyers should normally be closer to 40 percent of the market (Update: in November 2014 the figure has risen to 31 percent, still well below historical norms). An NAR survey showed that, of the first-time buyers who said it was difficult to save for a down payment, 54 percent said student loans made it tough to save money.

While overall prices have remained firm, existing home sales have softened from a 5.38 million seasonally-adjusted annual rate at its recent peak in July 2013 to just 4.62 million in January 2014 (Update: they stand at 4.93 million in November 2014). Today, amid ongoing limited inventory, there is mounting evidence that the housing market is decelerating and price declines are ahead. In January 2014, sales of homes under $250,000 (65 percent of the national market) actually declined 10.7 percent year over year.

Bringing it All Home
Most investors do not understand how much the growth of household formation is decelerating. Even those looking at the data assume we are experiencing a cyclical decline as opposed to a secular change. Given trends in employment, real incomes, debt service, and housing affordability, the outlook for Millennials does not support a housing growth cycle. For a growing majority of Millennials under age 35, the cost of housing as a share of disposable income is prohibitive to forming households.

Economists and housing bulls have yet to recognize and internalize how relatively poorer Millennials are than previous generations with respect to their capacity to secure paid employment and after-tax incomes and pur-chasing power to be able to afford to sustain a typical U.S. household and the traditional economic effects that has.

Most analysts, from the peak Boomer age cohort, are erring in extrapolating their own once-in-history demographic effects on housing, asset prices, employment, wages, and economic growth since the 1970s-2000s.