The Nikkei 225 index in Japan took out its previous peak of 39,000 and crossed a new high this week. The crazy thing is that the previous peak was reached 34 years ago in 1989. I know people (wrongly) say stocks always go up in the long run, but 34 years is too long. Why did it take so long and what are the lessons for investors today?
When the Nikkei hit its 1989 high, the Dow Jones Industrial Average (DJIA) crossed over 2000 or so. Today, 34 years later, Nikkei is again back at 39,000 and the DJIA is also at ~ 39,000 having advanced 19X over the last 34 years. The growth numbers for the S&P 500 and the Nasdaq would be much higher.
34 years is a seriously long time. It is more than most people’s investing lifetime. Why did it take so long?
I believe There are two key explanations for this.
The first is that for five to six years up to 1989, there was huge speculative boom in land and all kinds of financial assets, so at the market peak in 1989 the Japanese stock market was terribly overvalued and due a long correction. However, nobody would have expected it to last three decades.
The second reason is there are certain institutional and cultural reasons as to why the necessary cleansing and self-correcting mechanisms, which are inherent in capitalistic economy, just did not work in Japan. The writer Louis Gave has noted that while China is country which is nominally communist, its people are hard core capitalists. In contrast, Japan is a capitalist society on paper, but it has some deeply entrenched socialist tendencies.
These tended to favour the status quo and prevented the painful changes required to create the conditions for the economy and stock market to recover quickly.
We will consider these two reasons in more detail:
The great Japanese boom 1984-1989 was one where easy credit and excessive speculation led to a huge bubble, especially in real estate and stocks.
Form the 1950s to the early 1980s, Japanese policy emphasised an undervalued Yen to boost manufacturing exports. The policy worked too well. Japan ran up a huge series of trade surpluses with most countries, particularly the United States. The surplus was offset by net capital flows outside Japan which were invested in assets such as property in the US and Europe and US treasury bonds.
However, Japanese exports success, particularly in automobiles, caused great social and economic issues where autoworkers saw Japanese imports destroying their jobs. More generally, the Japanese surpluses in the global economy represented global imbalances. Global central banks met in 1985 and signed the Plaza accord whose main aim was to strengthen the Yen and weaken the US dollar.
The Japanese Yen did strengthen, esp. against the US dollar. Interest rates in Japan were lowered and the era of cheap easy credit began. People started borrowing to buy land and stocks. Japanese banks lent to their clients to buy assets in Japan and all over the world.
Japanese expanded their cross-border wholesale lending with aggressive pricing and became the largest in the world by assets.
By the late 1980s, it was said the land on which the Imperial Place in Tokyo stood was worth more than the whole of California. It was said that if you dropped a $20 bill on the street in Tokyo, the land under it was worth more than $20.
Japanese institutions bought the Empire State Building and the Rockefeller centre in New York and the Pebble Beach Golf Course in California. In 1987, Van Gogh’s Sunflowers painting was bought the Yasuda insurance company to display in an art museum on the 42nd floor of its Tokyo headquarters for almost $ 40m making it the world’s most expensive painting. There were many books published in Japan about Japan overtaking US as the largest economy.
The best description of the Japanese bubble was a book called “The Bubble Economy” by Christopher Wood which was published in 1992. Wood had been the Tokyo correspondent for The Economist Newspaper and had a front seat of the bubble and wrote well about its multi-faceted development in the 1980s.
Of course, like all bubbles, it could not last, and it peaked and collapsed quite spectacularly. Wood writing in 1992, speculated on the likely impact of the collapse on the Japanese Economy.
Wood later became chief strategist at CLSA and Jefferies in Hong Kong where his weekly Greed and Fear report is required reading amongst institutional Fund managers in Asia.
I remember reading his book in the late 1990s and re-reading it five years ago. It was amazing how most of his very negative forecasts made in 1992, about the fate of the Japanese economy and stock market, proved to be accurate.
Why did it take so long?
The first thing to state was the Japanese authorities tried everything to boost the economy and the market. In fact, they tried everything they could.
The Bank of Japan lowered interest rates to near zero and kept them there for decades. They continuously urged banks to lend. The government deficit widened greatly as the government boosted spending significantly. The whole of Japan was concreted over and roads to nowhere were built, and impressive bridges were added to connect them. This “investment” had such low returns it might as well have been called consumption.
The problem was it did not work. The Japanese economy and market remained in the doldrums.
Capitalism has always been characterised by cycles. An investment-driven boom and bust cycle is a recurring pattern of economic expansion followed by contraction. During the boom phase, investors are optimistic about the economy and pour money into various investments, driving up asset prices.
This leads to increased economic activity, job growth, and consumer spending. However, as the economy becomes overheated, inflation may rise, leading to higher interest rates set by central banks to cool down the economy.
This can cause a slowdown in investment and spending, triggering the bust phase. Asset prices start to decline, businesses may cut back on hiring, and consumers may reduce their spending. The bust phase can lead to a recession, characterized by a decrease in economic activity, rising unemployment, and falling asset prices.
Eventually, the economy reaches a trough and begins to recover, starting the cycle all over again. It's important for investors to be aware of these cycles and adjust their investment strategies accordingly to navigate the ups and downs of the market.
In the upswing, optimism is strong, animal spirits are elevated, and optimism is high. However, optimism drives optimistic investment, based on inflated projections.
However, eventually the cycle turns and economic growth plunges. At this point the degree of the previous miscalculations become clear. There are signs of overinvestment and over capacity everywhere.
The mistakes must be acknowledged, assets have to written off to their real value and losses have to recognised. Once this is done, assets are repriced, new investment will start, perhaps in different sectors to the one which prospered in the previous boom and the new cycle will begin again.
The top of the cycle marked by peak optimism contains the seeds of the next slump. At the bottom, the period of huge pessimism contains the ingredients for the next boom.
This essential mechanism was not allowed to work in the Japan for 30 years form 1990.
Part of the reasons for this are cultural and psychological. The Japanese are a conservative, cautious people. Organisations thrive on consensus decision making. This is by nature a ponderous and slow process. Aggressive, individualistic leaders are very rare. There is great emphasis on not losing face and a reluctance to criticise people in public.
There were several important institutional factors in Japan which are also part of the explanation. Many shares are cross holdings where many companies in loosely affiliated groups own large share stakes in each other. These holdings are seen as permanent and are thought to be vital to cement cross relationships.
Banks were reluctant to recognise bad debts, there was little regulatory pressure for them to do so.
Companies were reluctant to undertake tough restructuring which would have involved firing people and getting rid of non-core business.
Managements were under little pressure to change. There is no tradition of activist investors. The extensive cross holdings and social norms meant that hostile takeovers would never succeed.
Low interest rates meant banks could carry on funding their current portfolios, but profitability was low, growth was scarce and there was little funding available for new sunrise sectors which might have driven the upswing in the economy.
Many companies were zombie companies. They had enough cashflow to service their debts as interest were low but could not pay off the principles. However, banks were happy to rollover the debt as they had little incentive or inclinations to foreclose and to restructure.
Although growth was weak, there was little pressure for change. Japan is a rich country with little social division, low crime, no social strife and little sign of political radicalism. There were many large and small companies which had successful products and global market shares though increasing much of the production capacity was in China, Southeast Asia and elsewhere.
In short, life was pleasant for most Japanese and therefore there was little pressure for significant or rapid change.
The market hit a low in 2009 during the global financial crises and has recovered since them. Under Prime Minister Shinzo Abe (PM 2012 to 2020) there were some moves towards reform. Abenomics including low interest rates and government spending but also emphasised some pro-growth initiatives.
However, there has been a push in recent years for Japanese companies to change; to reduce or eliminate cross shareholdings, improve corporate governance and increase transparency. However, this being Japan change is slow.
The market has finally reached the 1989 peak, but bank stocks are still trading 80% below their all-time high. There is no great enthusiasm for stocks like the kind we see in the USA or India.
Investors have seen too many false dawns and are too cautious or conservative or old to take significant risk. Valuations are very low and some foreign value buyers have made good money in the last three or four years.
Some commentators argue that China seems to be following the Japanese path. There have been decades of overinvestment in China and a similar reluctance for banks to write off debts. The real estate bubble in China seems to be worse than in Japan. China like Japan also has an aging population. There are also many differences. Importantly, GDP per capita in China is much lower today than Japan in 1990.
What lessons can investors take from the Japan story. Economies and markets must allow capitalism to work as much as possible. To create booms, mistakes have to be acknowledged, assets written off and painful restructuring of companies allowed. Banks should be proactive in writing off debt and foreclosing lenders. There should be a tradition of activist investors and short selling should be allowed. Hostile takeovers should be attempted frequently and should have a level playing field.
There will be social and institutional pressures against all of these. Investors must look to invest in those countries where those pressure are weak or on the wane.