Japan's Stock Market History Offers U.S. a Cautionary Tale

On December 29, 1989, Japan’s Nikkei 225 stock index closed out a triumphant decade at 38,916. The Nikkei had begun the 1980s below 7,000 and had pushed above 10,000 in August 1984. It had nearly quadrupled in just five years.

But the Nikkei slid back below 30,000 barely seven months later, and would spend most of the 1990s below the 20,000 line. In the first few years of the 21st century, it often traded below 10,000. A rebound from 2003 to 2007 brought hopes that Japan had moved beyond its “lost decade.” But by late 2008, the Nikkei was back in the four-digit range, and in March 2009 it hit its lowest point since October 1982.

The Nikkei’s rise and fall exemplifies the building and bursting of an asset bubble. It also indicates that cleaning up the mess in the aftermath of a busted “bubble economy” can be a lengthy process indeed. The story takes on particular resonance amid the current U.S. economic crisis, with Japan’s 1990s economic policymaking often cited, albeit with varying interpretations, as a case study in what not to do.

The fall of the Nikkei was intertwined with plunges in other asset markets in Japan, particularly a real estate market that had become wildly inflated. At the height of the bubble, a square meter of Tokyo’s luxury-shopping Ginza district could reap a few hundred thousand dollars, and the nearby site of the Imperial Palace, though unlikely to be for sale, was famously estimated to be worth as much as all the real estate in California.

The reputation of Japan as a world-beating economic juggernaut also went southward as that nation sank into protracted malaise. The 1980s were rife with alarms in America and elsewhere about Japanese exports and overseas investment, reaching a crescendo when the Mitsubishi Estate Company bought a 51 percent stake in Rockefeller Center in 1989. Michael Crichton’s 1992 novel Rising Sun, in retrospect, marked a cresting of a wave of anxiety about Japan’s prospective economic dominance.

The 1985 Plaza Accord was widely seen as signifying Japan’s emergence as a major financial player. This international agreement pushed the dollar down and the yen up, in an effort to restrain America’s trade deficits and Japan’s trade surpluses. As such, it also had a dampening effect on Japan’s export-led growth, which prompted the nation’s monetary authorities to pump out more yen to encourage domestic consumption and investment. This would work all too well, fueling the upward surge of asset prices.

Equity prices soared, with Japan routinely outperforming the rest of the world. Moreover, a euphoric sense took hold that there was nothing unsustainable about the country’s stratospheric price/earnings ratios. The P/E on Nippon Telephone & Telegraph was over 300 by late in the decade. “The Japanese have their own way of thinking about stocks, and I don’t understand it yet,” a puzzled but intrigued Peter Lynch wrote in his 1990 book One Up on Wall Street. “Every time I go over there to study the situation, I conclude that all the stocks are grossly overpriced, but they keep going higher anyway.”

A Long Way Down

By the time Lynch’s words saw print, this mysterious levitation was already ceasing to occur. The Bank of Japan, worried about soaring housing prices, had started lifting interest rates, putting a brake on the mania fueled by easy money. And there was trouble brewing in the world economy, exacerbated by Saddam Hussein’s invasion of Kuwait.

The crash took place in stages, like a slow-motion nightmare. Initially, there was widespread belief that Japan was merely going through a mild recession, prelude to a continued boom. Property values continued rising for months after the Nikkei started its descent, but by 1992 both were in steep decline. Interest-rate cuts failed to reverse a growing banking crisis, as dud loans piled up and banks’ stock holdings headed down.

The interlocking nature of Japanese stock ownership, with financial institutions owning large chunks of other companies, had once seemed to be an ingredient of the nation’s economic success, one that contributed to the Nikkei’s 1980s rise. Increasingly, it now came to be seen as a problem, with banks’ stability tied to a volatile equity market.

As Japan moved in and out of recession throughout the 1990s, Japanese stocks put in a lackluster performance, notably contrasting with the bull market taking shape in the U.S. and various other countries. The Nikkei fell below 13,000 in 1998 before rallying to almost 19,000 at end-1999. These gains mostly slipped away in 2000, however, and as equities fell worldwide following the September 11, 2001 terrorist attacks, the Nikkei went lower than 10,000 for the first time since 1984.

On November 14, 2002, the Nikkei sank below the Dow Jones Industrial Average, closing at 8,303 compared to the Dow’s 8,542. This crossing of paths would not last long, but prior to Japan’s lost decade, it would have been difficult to imagine such a thing happening at all. On the last trading day of the 1980s, when the Dow closed at 2,753, the American benchmark had been about one-fourteenth of the high-flying Nikkei.

The rebound that began in 2003 brought the Nikkei from a low of 7,607 on April 30 of that year to 18,261 on July 9, 2007. But a steady descent brought the index into the 13,000 range by mid-2008 and the decline became precipitous as equities around the world deflated last September. With the Nikkei lately still mired in four digits, Japan’s economic debacle is ongoing, and the lost decade now threatens to stretch into a pair of lost decades.