Some of the recent economic indicators are lining up with what we saw in Japan in the late ’80s, prior to the massive stock crash which led to what’s known as “the Lost Decade”.
It’s wise to pay attention to some of the warning signs that might be out there.
The collapse of the Japanese stock market in the early ’90s should always be in the mind of equities traders. Not just because it was dramatic, but even almost thirty years later and massive amounts of fiscal stimulus, the Nikkei has still not recovered.
This goes against conventional wisdom for investment that indices, on average, grow over the long term.
Why We Should Worry
Generally, the cause of the Japanese Asset Bubble (and subsequent burst) is still a subject of extensive debate. In fact, as GB Shaw said, “if you laid out all the economists in a row, they’d never reach a conclusion.”
However, the main consensus is that stock prices moved higher, well out of proportion to their underlying value. This was partially due to a lack of action by the BOJ, coupled with a significant expansion of the monetary base.
Today, we see stock valuations in the tech sector well beyond reason. There are also unprecedented levels of margin in the market, and central banks are desperately pushing money into the market.
Those are not the uncanny similarities, though.
Tears in the Rain
The ’80s saw a rise in expectations that Japan would become the world’s economic powerhouse.
In fact, you could see it in the movies of the time. In Blade Runner, for example, the future is portrayed as a mixture of English and Japanese.
Japan, in many ways, occupied the same place as China does today. It was a massive exporter and manufacturing base.
In fact, the US allegedly put pressure on Japan to increase the yen in order to reduce the trade deficit. Japan at the time was the largest holder of US treasuries. It wasn’t a trade war in the form of tariffs, but it was a political trade policy nonetheless.
What Could Happen?
Of course, the world today isn’t exactly the same. However, in the interest of being prepared, what could happen if there were a similar asset burst, but this time in the whole world?
The most vulnerable index would be the Nasdaq because it is the heaviest in overvalued tech stocks. The third-largest component – Amazon – doesn’t even pay a dividend, and trades at a P/E ratio of 122.
The more diverse S&P 500 would fare better, with companies having more reasonable earnings ratios offsetting some of the losses. Ironically, some of the less solid stocks could perform better, simply because they are less leveraged.
A Bursting Bubble Lets Out Excess Margin
The DJIA might initially have a steep decline because, as all of its components are blue-chip, brokerages allow higher levels of margin investing. But the index could recover quite quickly since the components have solid valuations.
As indices rise in the middle of a pandemic and decreasing revenue for most companies, people will likely keep fretting that the stock market is disconnected from reality.
The big test will be when the central banks have to stop the flow of infinite money which is propping up stock prices.