Lessons learned from Japan's equity market

Japan’s equity market is somewhat especial. It experienced a massive asset price bubble in the 80s, the rippling effects of which are still felt today. This entry reviews the lessons learned from Japan’s equity market.

Why focus on Japan’s market to begin with?

If you invest in something like VT (which this site recommends), your exposure to Japan’s equity market is ~7% of your market value. That’s significant – actually the second largest exposure at the time of writing (after the US). But it still wouldn’t warrant deep diving into Japan’s equity market. At least not with the intention of steering or fine-tuning our investments. Not if we’re long-term passive investors, anyways.

The reason why I like to look at Japan’s equity market is different. To understand it, we have to first think of how equity markets theoretically work.

Generally speaking, stock markets are quite noisy and volatile in the short term, but enjoy (quasi-) exponential growth over the long run [1]. Why exponential growth? Because, roughly speaking, humans have experienced a sustained exponential economic growth over the past 200 years. This is linked to technological development [2]. And what’s “the long run”? Difficult to tell, but, from an investment perspective, a timespan of 20-30 years is generally deemed sufficient to minimize volatility risks when investing in equities.

With this background in mind, Japan’s equity market is interesting because it distinctly deviates from the textbook model. For the worse, unfortunately. Japanese equities have not experienced exponential growth in the last three decades.

The performance of Japan’s equity market

What is the Nikkei 225?

The Nikkei 225 is the leading and most popular index of Japanese stocks. As the name suggests, it comprises of 225 large Japanese public companies [3]. Some of the best-known companies in the index are Toyota, Sony, Nintendo, Nissan or Honda. The Nikkei is a price-weighted index (as opposed to e.g. the S&P 500 which is market cap-weighted).

What’s the past performance of the Nikkei?

Following a period of strong growth during the 70s and – especially – the 80s, the Nikkei reached an all-time high on December 29, 1989. On that day, the index closed at a level of 38,957 [4]. In other words, the Nikkei peaked more than 30 years ago. And hasn’t recover since.

Source for the chart data: macrotrends.net

Is it really that awful?

No. At least not in total return terms. Like most other well-known indices, the Nikkei we often see quoted is a price index. As explained in this entry, a price index doesn’t account for dividends. A total return index does. It assumes investors reinvest all dividends received back into the index.

If we account for dividends, the picture turns slightly brighter:

Source for the chart data: dqydj.com

In the chart above, the price level is standardized to 100 on year end 1989 to facilitate the comparison. The difference is clear. Accounting for reinvested dividends, someone who invested on December 1989 would be down ~8% as of year end 2019. The price index, in contrast, is down ~38%.

This is still pretty bad…

8% down over a timespan of 30 years is still quite bad. Even more so considering dividends are accounted for. This is not what you expect when you invest in equities.

To compare, let’s put together the total returns of the Nikkei and those of the S&P 500. The latter is the main gauge of the performance of US equities. To contain the bias induced by cherry-picking dates, the table below considers five different starting dates:

Invested in	Invested until	Annualized total return Nikkei 225	Annualized total return S&P 500
Jan 1990	Dec 2019	-0.29%	9.96%
Jan 1995	Dec 2019	2.27%	10.22%
Jan 2000	Dec 2019	2.88%	6.06%
Jan 2005	Dec 2019	6.89%	9.00%
Jan 2010	Dec 2019	10.63%	13.56%

The returns are annualized, which means that they’re transformed to a yearly “average”. For example, someone who invested in the Nikkei in 1990 would have experienced the equivalent of a 0.29% decline per year for the next 30 years.

The conclusion is clear: compared to US equities, Japanese equities have vastly underperformed over the last 30 years. This is valid for several different entry points.

What if you had invested progressively?

Let’s look at it one final time from a different angle. A realistic scenario for most of us is to think of periodical investments. Say we had invested $20k per year, starting at the peak of the bubble. Assume we reinvested dividends. What would have happened?

This is not that bad. Which makes sense given we bought low at post-crash prices. The curve looks pretty much the same had we started in 1980 or in 1985, when the bubble was forming. As discuss in this entry, the lesson learned is to always stay the course. Even during a bear market.

Why did this happen?

The short answer

The short answer is that period of growth ahead of the 1990 crash was artificial and unsustainable. Asset prices were in a bubble. Just look at the Nikkei 225 chart again. During the 80s, the price of the index grew sixfold. That means annualized returns of ~20%. That’s without even considering dividends. And for a whole decade!

The more elaborate answer

Japan boomed in the 80s. Exports – among other reasons – fueled the country’s economy. Japanese steel, Toyota and Honda cars, color TVs, the Walkman, and other consumer electronics found a worldwide market [5]. Experts were trying to predict when Japan would surpass the US as the biggest economy in the world [6].

The US, at the same time, wasn’t doing so great. That prompted the US to push for the Plaza Accord. The Plaza Accord had the goal to increase the competitiveness of American and European exports against the (at the time) almighty Japan. How to do it? By intervening currency markets to artificially depreciate the USD against the Japanese yen (JPY).

When a country’s currency appreciates, like the JPY did, exporting becomes difficult. Your goods become comparatively more expensive elsewhere. To dampen the blow, the Bank of Japan changed its stand to a monetary easing policy. And so, they lowered interest rates. Researchers agree that the aggressiveness and duration of such monetary easing was excessive. Money growth spiralled out of control [7], fueling the asset price bubble.

This bubble was patent in the stock market. The PE ratio of the Nikkei was above 60. Japanese equities were 45% of the world’s by market cap [8]. But it didn’t just affect the stock market. Land prices also skyrocketed. The price of land increased by 5,000% between 1956 and 1986 [9]. And, fun fact, it was said that the value of the Tokyo Imperial Palace was higher than that of all the real estate in California [10].

This is still, of course, a simplistic explanation. Excessive loan quotas, financial deregulation, overbanking, regulations that encouraged higher land prices, a shrinking population, and a general sentiment of euphoria are also contributing factors researchers quote [11, 12, 13].

What it implied for Japan

The 90s are referred to in Japan as the Lost Decade. It took 12 years (to the year 2007) for Japan’s GDP to reach again its 1995 level. Real wages fell ~5% [14]. Aggregated after-tax (and net) return on capital fell from 6.1% in the late 80s to 4.2% in the late 90s [15]. Overall, the Lost Decade was a long period of economic stagnation that crippled Japan’s economy.

Even today, 30 years after the original crash, Japan still feels the rippling effects of the Lost Decade. The Bank of Japan hasn’t been able to significantly rise interest rates since. The share of temporary workers – referred to as haken – is still close to 40% [16]. Even this article from last week focuses on how Japan’s Lost Generation is still jobless and living with their parents.

Interest rates in Japan — Evolution of interest rates in Japan. Extracted from Wikimedia

What can we learn from Japan’s equity market?

By now you hopefully have a good understanding of Japan’s asset price bubble. What can we learn from it? From my subjective perspective, three things:

Investing in equities will always be risky
Diversification remains a core investing principle
Valuations are no silver bullet, but can still be meaningful

1. Investing in equities will always be risky

If you’re like me, one of the first questions popping up in your mind after thinking of Japan’s Lost Decade is: can this happen to other Western countries? Say, to the US, where most of my exposure is concentrated?

The likelihood to have a scenario à la Japan in the US anytime soon is quite low. This is also the market consensus. Current high valuations would be difficult to justify otherwise. The truth is, there are hundreds of factors that make the US and Japan different. Most notably demographic growth, market structure and culture. The circumstances are simply so different that it seems highly unlikely to have a scenario similar to Japan’s asset price bubble in the US any time soon.

This is not to say the US market is risk-fee. There are thousand other factors that could propitiate a similar or even worse crash than Japan’s. Many of them we can’t even imagine right now. Put differently, we can get to the same effect with completely different causes. What looking back at Japan in the 90s reminds us is that massive value losses are a risk we implicitly accept when we decide to invest in equities. As we saw above, we have to be prepared to stay the course and keep investing periodically even in such scenarios. This is the only way to deal with it. If we’re not comfortable with this, we should reduce our equity exposure.

2. Diversification remains a core investing principle

You’ve heard it a thousand times. And hopefully also read it in this entry. Diversification and will always be a core principle to keep in mind. The 1980s asset bubble was surprisingly idiosyncratic to Japan. Yes, the world is more globalized now and markets are more correlated. But, still, you can diversify away similar country-specific black swans.

We said it’s unlikely a scenario exactly like the one in Japan plays out in the US. But it’s actually quite likely that, for whatever reasons, the US underperforms international stocks. Don’t put all eggs in one basket.

3. Valuations are no silver bullet, but can still be meaningful

As briefly mentioned above, the PE ratio reached stratospheric levels during Japan’s asset price bubble. The chart below shows the evolution of the Cyclically Adjusted PE ratio (CAPE). Check out this entry if you’re not familiar with it.

Japan Nikkei 225 Shiller PE CAPE — CAPE ratio (blue) vs 3-year forward stock returns (orange, inverted scale) for the Nikkei 225. Copied from siblisresearch.com

In the chart we can see that the CAPE steadily increased during the 80s. By 1988, a couple of years before the bubble burst, it was already 60+. Hindsight is, of course, 20/20. Investors at the time might have thought that such a CAPE was justified by earnings growth. Amazon’s PE ratio today is 120+, after all.

I’m a passive investor. And I don’t advocate for the use of valuations to design an active investment strategy (more on active vs passive investing here). But still, thinking of Japan’s bubble burst triggers some interesting questions. How do you think you would react if all bubble metrics were flashing red? Say, one similar to Bitcoin’s 2018 bubble? Would you stay the course? If anything, thinking of what happened in Japan forces us to reflect how passive we want to be.