Different this time?

If you read this blog, you are no doubt aware that the author of these many tomes thinks that stock markets worldwide are primed to fall very significantly at some point, just like they did in 1981-82, 1987, 1990, 1998, 2000-01, 2007-08 - you get the picture. This will happen again, it is only a matter of time. 

With the stock markets having reached new heights in January, but not having yet recovered above those heights after their pull-backs in February - in spite of massive buy-backs fueled by Trump’s tax cuts - this inevitable drop may be very close indeed.

So what? 

I have been through a number of very serious, and somewhat less serious downturns in the past 35 years. Every single time, the markets have roared back to new highs. If markets drop, history suggest that they will recover, and just continue their march to new heights. Stay in, and all will be well. For the last 100 + years, this formula has worked.

Unless you live in Japan. In 1989, the Nikkei 225 Stock Index, Japan’s primary stock market, topped out at over 38,000. In late 1989 and 1990, it started to drop, and then plummeted to under 20,000 – about a 50% decline. Today, it is flirting with 22,500.

Unlike what happened with the DOW and S&P 500 over the past 100 years, after the Nikkei 225 Stock Index dropped in 1990, IT NEVER RECOVERED!  It is still down over 40% from its 1989 highs. Here is a chart that well illustrates the drop.

 

Why has the Nikkei never recovered? Are there any similarities between the situation Japan faced in 1989 and since, and what we face today that suggests that a similar fate could befall our markets after the next inevitable drop? Let’s look at what happened and at what is still happening in Japan.

Japan was massively over-leveraged in 1989, after having experienced one of the most historically significant real estate bubbles in human history. In the 1980’s, the Japanese real estate bubble became so crazed that borrowers were able to purchase three-generation mortgages, and the value of the land surrounding the Imperial Palace was higher than that of all of the real estate in the State of California.

Japan had also started to age significantly about that time, as its birth rate plummeted well below the rate needed to replace the population. The birth rate has never recovered, and Japan now has the second oldest population on Earth.

Japan, after a fantastic decade in the 1980’s, which saw it grow to an export-based economic power-house, faced significant pressure from its export partners in the USA and Europe to restrict its exports, and to locate production in those countries, especially production of automobiles.  

Finally, the Japanese government, in an attempt to stimulate the economy started borrowing and spending massive amounts of money. Today, on a debt to GDP basis Japan is the most indebted industrialized country on Earth, with the government owing more than 250% of the country’s GDP in debt.  

Why does any of this matter, and how may it have impacted Japan’s stock market?

A stock market is an almost direct representation of the economy. The stronger a given economy, the more robust will be any associated stock market.

The Japanese were hit with a number of very serious economic impacts at about the same time, especially the drying-up of leverage that drove a collapsing real estate bubble; new export restrictions; and an associated stock market pull-back. 

These, in and of themselves, would not normally have been fatal to a stock market recovery. Although the Japanese were very slow to deal with the mass of bad debt following the collapse of the real estate bubble, they did eventually sort much of this out. So why has their market never recovered?

What I think has limited the Japanese stock market recovery has been demographics. Retired people earn, borrow and spend far less than working people. An ageing and aged population has meant the slow strangulation of domestic demand in Japan, and while productivity and technological change no doubt drives some new growth in the Japanese economy, this has not been enough to off-set the drop in demand. 

The fact that the Japanese do not accept immigrants like, for example, Canada or the USA, has meant that they have not been able to import new domestic demand to replace the demand that has been lost owing to their ageing population. 

In short, retirees are killing that economy. As the economy has stagnated, so has the stock market in Japan reflecting the basic reality that a stock market is not going to go up if economic demand is moving down.

What about us?

We have a series of bubbles occasioned by the lowest interest rates in history, including a real estate bubble and a bubble in the stock market. We having looming and active trade wars that may hit our exports hard. We have very little room left to borrow so as to spark new demand. And, we have an ageing population, with the number of retired people set to double as a proportion of the population over the next 20 years or so.

In many respects, we are the Japan of 1989. This is serious.

I have previously highlighted Keynes v Hayek on this blog. Both the “prime the pump” theory of Keynes and the “let the recovery happen” theory of Hayek in response to economic downturns assume economies have increasing economic demand via expanding populations and increased innovation.

But what if the opposite is true?

The great economic policy crisis of our time may be that we don’t actually have an economic theory that addresses a situation of long-run flat or even negative economic demand – a naturally retracting economy, as opposed to a naturally expanding one.

The next serious stock market pull back is coming – there is always another one. 

No one knows when it will hit, but one may want to start to to question whether the logic of old – “stay in and all will be well” will apply this time. At the very least, if we experience a Japan-light scenario, the market will recover, but only very, very slowly.