The Markets: Doomed to Repeat?

Some financial experts who know the history of U.S. markets inside and out are nonetheless oblivious to the history of stock markets around the world. This has always puzzled me. Do these other markets have nothing to teach us?

Stock market history is a valuable field of study, but sloppy or biased history can deceive us and give us false hope about our investment future. We need to be careful about which market historians we follow. Analysis of market history must be objective, and must not focus on markets or time periods that create unrealistic expectations, and thus false hopes.

With such a limited market history, it surprises me that so many historians have decided to ignore one of the largest markets in the world: Japan. The world’s second-largest economy contains vital lessons which American investors would be wise to heed, but that history is rarely examined in this country. Is it because the story it tells doesn’t support a passive investment philosophy?

Markets exhibit a high degree of randomness. We should remind ourselves that a single time series only tells us about one of an infinite number of potential outcomes–I call them alternative histories. A lone set of outcomes is all history provides, so we must examine it carefully. Moreover, we shouldn’t consider just those slices of history that provide the most pleasant results: We must be aware of the alternative histories that didn’t take place but could have. Monte Carlo analysis, although it isn’t perfect, is an excellent tool for studying alternative histories.

If we seek integrity as a researcher or market historian, we can not discard histories (actual or alternative) that fail to provide the outcomes we want. Research is all we have when it comes to forming reasonable assumptions about future markets.

Although this seems obvious, it is worth stating–we have to understand that future events will differ from the past. History may be a rough guide, but it is far from a reliable map. History shows us what stocks have done, but it’s the critical interpretation of that history that influences our investment decisions.

Because understanding the lessons of market history is a much more complex task than many would have us believe, much of what we learn about market history depends on the historian–and that’s potentially dangerous if the historian is biased or ignorant. Be skeptical of the market historian whose goal is to sell a product or a service. Ask yourself if they have a conflict of interest. In fact, every market historian should be read with a healthy dose of skepticism.

Stocks for the Long Run?

The Tokyo Stock Exchange (TSE) was established in 1878, about sixty years after the New York Stock Exchange (NYSE) adopted its first constitution. In 1943, the TSE merged with 10 other stock exchanges in major Japanese cities to form a single Japanese Stock Exchange. By 1990, stocks on the TSE accounted for over 60% of the world’s total stock market capitalization, making it far and away the biggest stock market on earth at the time.

The last two decades, however, have been disastrous for anyone holding Japanese stocks. Between 1989 and 2009, the Nikkei 225 Index lost 82% of its value. In other words, a $100,000 investment made 20 years ago in a fund that tracks the index was worth about $18,000 in March of last year. Since then the index has rallied 52%, but it is still down over 73% from its 1989 high. Today, the Japanese stock index still needs to climb an additional 164% to return to that 1989 high.

If you were a 40-year-old investor in Japan in 1980 and used a buy-and-hold strategy, in March 2009, at age 69, you would have had a portfolio worth less than what you started with nearly 30 years earlier.

Your run-of-the-mill market historian might say, “Okay, that’s Japan, it’s a much smaller economy,” completely unaware of, or disregarding, the fact that the Japanese stock market was the world’s largest 20 years ago. In economic terms, Japan certainly is no slouch. Even today the Japanese economy is second only to that of the U.S.

If this example doesn’t suggest to you that buy and hold is crazy, maybe a picture will help.

Doug Short (www.dshort.com) is one of the most dedicated and intelligent stock market historians I know. He studies markets like teenagers study television. I asked Doug to create the table below and the following chart, so we can examine the once-mighty Japanese market.

Still Hanging On, But Why?

If you are wondering why some investors are still hanging on in Japan, you are asking the right question. The Nikkei’s 20-year decline has been anything but smooth. As we can see, the index has gyrated all over the place, giving the passive investor fits.

Amid the long-term slide, there were bright spots. The table shows each of the bear market rallies since the 1989 high, and we can see that five of the six rallies were over 50% and one added 135%. Each one could have been the start of a new bull market, but no–five would-be bottoms proved to be mere interludes before the pain resumed, and hope kept stubborn investors frozen as their wealth continued to erode.