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August 22, 2003

Japan and US Busts
by Adam Hamilton

The study of market history is so valued by prudent contrarian investors because we humans collectively never seem to learn from the great financial mistakes of the past. While the unfortunate generation that actually makes these mistakes learns really well, future generations soon forget these hard lessons and are thus doomed to repeat history.

Market history never repeats itself exactly since each particular financial-market situation is unique to one brief era that spawned it. Nevertheless, while not identical various extraordinary situations throughout market history still certainly tend to rhyme with each other. Especially the great booms, bubble, bursts, and busts that rear their heads once every few generations or so in a given nation.

These powerful cyclical phenomena are so similar in different episodes in history precisely because they are driven by the same undying forces. The most important of these are greed, fear, and herd instinct, innate traits woven deeply into our human hearts that have never changed and will never change regardless of advances in civilization, technology, and communication across eras.

As long as we inherently emotional humans are involved in investment and speculation, great manias and their devastating aftermaths will continue to slam into the financial markets once every 60-year-or-so Kondratieff economic cycle. And since we find ourselves in one of these peculiar events right now, our best hope as investors to weather this brutal storm is to strive to understand the past so we can gain a good idea of what we ought to expect in the rest of our own post-mania era.

While we would typically have to dig back three generations in dusty tomes to vicariously witness the post-bubble bust aftermath through the eyes of those who actually lived through it long ago, today investors are blessed to have an honest-to-goodness ongoing bust in Japan to which we can look for insights.

The Japanese experience offers an enormous feast of food for thought for American investors today, as the Japanese stock markets are about a decade farther into the bust process than we are so far in the States. In some ways, looking at Japan today is like peering into an extra-dimensional window into the immediate economic future of America.

One extremely important question in particular being zealously pondered by American investors today has many looking to Japan for answers. It involves the prospect of a mighty decade-long trading range in the States, similar to what Japan witnessed after the first few two-and-a-half years or so of its plummeting stock prices following the burst of its notorious Nikkei 225 bubble in late 1989.

This potential US-trading-range question is so important because the necessary strategies for successfully investing in a bull market, bear market, and sideways market are quite different. If the US markets are really destined to meander sideways for many years like Japans, then neither purely bullish nor purely bearish capital-management strategies will always fare particularly well.

The best way to understand the origins of this trading-range question is to observe the post-bust-trading-range action from Japan in comparison with the US stock markets. The range of similarities between the major US markets, particularly the flagship S&P 500 and speculative-mania-ground-zero NASDAQ, and Japan's elite Nikkei 225 stock index is quite striking. History is definitely rhyming in these two busts, no doubt about it!

Our graphs this week attempt to accomplish this mission by rendering these unique trans-Pacific markets in similar percentage terms for accurate comparison. Since the Nikkei 225, S&P 500, and NASDAQ are all currently measured at such vastly different index levels, we converted each index into an identically indexed scale between 0 and 100. 100 represents the respective bubble tops on each index while 0 is, well, zero!

All of the data graphed below is weekly from each respective index, so the horizontal scales are denominated in weeks. Week Zero is the bubble top for each index, while negative weeks count down to the bubble top before it transpired and positive weeks count up from the bubble top after it collapsed. Each vertical gray line on the first two graphs below corresponds to 52 weeks, one year, so it is best to think of the graph squares in terms of years.

By rendering the Nikkei 225, S&P 500, and NASDAQ in comparable percentage and time terms, easy visual comparisons can be made to help us compare and contrast the similar yet still unique boom, bubble, burst, and bust experiences of each of these three elite stock indices. This exercise also illuminates the all-important decade-long trading-range question in the States.

The grand strategic picture is shown in our first graph, which encompasses the entire modern history of the Nikkei 225 and superimposes the S&P 500 and NASDAQ experiences on top of it. After you spend a minute or two drinking in this chart, you will totally understand why the Nikkei 225 experience is leading so many investors today to believe that the US markets are in for a long sideways trading range.

When you consider the vast cultural and financial differences between Japan and the United States, the similarity in these boom-bubble-burst-bust profiles from each country is absolutely remarkable. While the patterns carved by these mighty market events in both countries are not identical, they've certainly rhymed amazingly well.

On their initial boom ascent phases, both the Nikkei 225 and S&P 500 managed to carve almost mirror-image upslopes. From 260 weeks before their respective bubble tops to their very bubble apexes at week 0, the Nikkei and S&P lines are essentially interchangeable. If we were to create some graphs without any labels or numbers for reference, I bet that not even a tiny fraction of serious students of market history could identify which ascent phase belonged to the Nikkei and which to the S&P.

Once its all-time high was reached, the S&P 500 stopped tracking the earlier progress of the Nikkei 225 and desperately tried yet failed to attain a new high almost a half year after its March 2000 bubble top. This long American topping process effectively decoupled the Nikkei and S&P connection and ended the intimate interplay of their respective price lines. Today the S&P 500 still shows similar patterns as the Nikkei 225, but at a much higher absolute index level than what was witnessed in Japan.

Interestingly however, beginning at these bubble tops the maniacal NASDAQ started to track the Nikkei bubble burst exceptionally well. Both indices fell by more than 45% from their all-time highs in a matter of only 40 weeks or so!

A horrific 45%+ loss from an all-time-high in a major index in only 40 weeks is a frightening event to witness that usually only happens off of major supercycle bubble bursts. Thankfully today's American investors are unlikely to ever witness anything like this again, since these types of bubble events are exceedingly rare and generally only spawn once every three generations or so.

Since about the first year after their respective bubble tops, these three great busts have followed similar downward trajectories but at very different absolute indexed levels. The NASDAQ plummeted hard and fast as the tech stocks were the most ludicrously overvalued of the entire US mania, speculative ground zero. The S&P 500 had many more blue-chip companies that were expensive, but at least they could still earn some profits for their shareholders so its descent has been much slower. The Nikkei 225, interestingly, has tracked almost exactly in the middle of the S&P 500 and NASDAQ.

The origin of the long-trading-range idea for the US markets is crystal clear on the chart above. The S&P 500 has tracked the Nikkei 225 rather well so far in our own American boom-bubble-burst-bust. The Nikkei fell aggressively for 135 weeks after its ultimate top and then suddenly entered an utterly massive decade-long sideways trading range. As goes the Nikkei so goes the S&P?

Provocatively the mighty S&P 500's latest major interim low of last October happened 131 weeks into its own bust, so per the Japanese model the timing was about right for a major interim low to be carved. The S&P 500 bear-market rally since then has also tracked the Nikkei's earlier example rather well, as the zoomed-in charts below illuminate in more detail.

It is certainly easy to understand why the long-US-trading-range theories are gaining ground in the States in light of the remarkable similarities between the Nikkei 225 and S&P 500!

Interestingly the bulls seem to be the most excited about this trading-range idea, since to them it means that the Great Bear market will quit mercilessly rending their flesh from their bones. Yet, the long Japanese trading range was anything but bullish. While it started about two-and-a-half years after the Japanese bubble top, it lasted for almost a decade before breaking down to horrific new lows. Rather than a tolerable three-year bear market, the long Japanese trading range multiplied it into a thirteen-plus-year Monster Bear!

While the initial bounce that heralded the Japanese trading range happened around this time frame in Japan, its ultimate bear-market low wouldn't be witnessed until at least a decade later. While a 60%+ loss over two-and-half years seemed bad in the early 1990s in Japan, today's 80%+ loss over a dozen-plus years after the top seems infinitely worse. Since we mortal humans only tend to be blessed with four or five decades of good investing time during our short sojourns on Earth, we absolutely cannot afford over a decade of losses.

Can you imagine the wailing and gnashing of teeth in the States, not to mention the utter destruction of general enthusiasm for investing, if a decade from now the S&P 500 trades down to less than 50% of even last October's "low" levels? It would be financially ugly and psychologically devastating, an exceedingly bearish thing!

So, while many bulls today like the prospect of a Japanese-style trading range since it means to them that the brutal bear market is about over, they ought to look twice at the Japanese experience. In many ways a grinding, excruciating decade-plus-long Great Bear is ultimately far more destructive than a more rapid one that only lasts a few years like the early 1930s experience in the States.

What's ultimately less painful, a violent kick in the teeth for a few years or seemingly endless torture for a quarter of one's adult investing life? Personally I'll take the kick any day over the torture!

So, while the prospects for a similar decade-long trading range in the States like Japan's are very real, it is crucial for investors to realize that the Japanese Great Bear experience was and still remains to this day an exceedingly hostile environment for long-term capital growth and wealth creation. If some perma-bull tries to convince you that a Japanese-style trading range is a happy thing compared to a fast and wicked Great Bear bust, don't be so sure.

By zooming in we can gain a greater understanding of how the US bust is tracking the Japanese bust today.

At this shorter-term scale the raw similarities at times between the Nikkei 225 and the S&P 500 or NASDAQ are downright uncanny! Some of the particular ascent-stage bumps in the Nikkei and S&P are practically identical to the week. The mirror-image signatures of the attempted double tops in the first major bounces after the initial index crashes in both the Nikkei 225 and NASDAQ are utterly amazing. History continues to rhyme, richly rewarding the prudent contrarians who take the time to learn its countless lessons!

Of particular interest to me are the recent October 2002 interim lows in the US markets, which so closely match the initial major bounce leading into the long trading range in Japan. As I mentioned above this bounce happened on week 135 for the Nikkei, week 131 for the S&P, and week 133 for the NASDAQ. This fascinating parallel is even more apparent if we zoom in one last time to the bust stages witnessed in each nation's respective markets.

This final chart is divided into 26-week chunks on the X-axis, half-years. The post-week-130 parallels between the three busting indices are really extraordinary and have added a great deal of popular support for the long-US-trading-range thesis.

In all three indices, an initial major interim low was carved soon after week 130 which then led to a sharp bear-market rally. This initial bear-market rally soon faded like all bear-market rallies do, but it did not collapse to fresh new interim lows. Instead a modestly higher interim low was achieved and then a second bear-market rally hit and launched each index up to new interim highs above the previous bear-rally tops.

These first interim highs achieved around week 173 or so defined the initial upper end of the Japanese trading range, something to bear in mind as the June highs in the States actually transpired almost exactly on this very week on the Nikkei schedule.

Once again there is no doubt that the pure technical price-only comparisons are amazing. In examining these charts it is really easy to understand why so many technical analysts are placing so much faith in the Japanese trading-range model holding true for America over the coming years.

The only pure technical objection that can be raised is the much higher level for the S&P at this stage in the bust (65% of its all-time bubble top) compared to the Nikkei 225 (54%) in April 1993. In absolute indexed terms, the S&P is currently trading 22% higher than the Nikkei 225 was at this stage in its own bust, quite a bit higher. This ought to trouble the trading-range enthusiasts, yet I haven't heard anyone bring it up yet.

While the pure technical price comparisons are stunning, price alone isn't everything. I realize this is heresy to technical analysts, but many factors lead to the buying and selling that ultimately directly sets free-market prices. Over the long-term valuation matters, as investors need to earn a reasonable return in the few short decades of good investing that most can expect in their lives. In addition, the constantly warring emotions of greed and fear drive short-term activity and hence prices, so sentiment must also be considered.

The key component to understanding booms, bubbles, bursts, and busts is valuation. Stocks get overpriced in bubbles due to rampant popular mania greed and then they get underpriced in the subsequent busts as valuations mean revert and overshoot. This over-then-undervalued cycle is witnessed in all of the booms and busts in stock-market history.

Undervaluations during busts inevitably follow overvaluations during bubbles like winter follows summer. Like the seasons the Long Valuation Waves are nonnegotiable, impossible to stop! General-market valuations are measured by the classic valuation metrics of general-stock price-to-earnings ratios and dividend yields.

Having spent years of my life studying stock-market valuations in booms and busts, I believe that no boom and bust analysis is complete without considering current valuation multiples. Today the S&P 500 is trading near 26x earnings, still almost in official bubble territory at 28x! Meanwhile it is only yielding 1.7% in dividends, abysmally low by all historical standards.

Meanwhile the hyper-overvalued NASDAQ remains a classical bubble to this day at 38x earnings and yields nothing in dividends. These grossly excessive valuations reveal that today's US index levels remain far, far too high based on the actual collective underlying earnings power of the publicly-traded corporations that comprise them.

Historical Great Bear bottoms only happen at general-market P/E ratios under 10x earnings and general-market dividend yields over 6%. The general US stock markets will get there too in this bust, either via continued sharp falling or by an excruciating decade-long grinding lower, just as happened in Japan. But with US stock valuations still remaining this crazy, there is absolutely no question whether or not the Great Bear is finished. It is not! It will return to maul investors until general valuations are once again historically low.

So while the technical Japan/US comparisons are certainly provocative and worthy of study, they are woefully incomplete when valuation is not considered as well. While I always know exactly where the US markets are trading in valuation terms, unfortunately my team and I have been unable to secure historical Japanese valuation data. We have been looking for several years now for monthly P/E and dividend yield data for the Nikkei 225, but no one seems to have it.

Until you and I can fully understand the kinds of valuations at which the Nikkei 225 actually traded during various stages of its own bust, we really can't make any comprehensive comparisons. As always, if we get a hold of this data at Zeal I will not hesitate to write an essay on it to share the insights. Needless to say, if you have this priceless Nikkei 225 valuation data I would love to hear from you!

If the Nikkei 225 was as overvalued as 26x earnings at this stage in its own bust like the S&P 500 today, then I suspect that we have a much higher probability for a long US trading range dawning than if the Nikkei was already much less overvalued by this time. For example, if the Nikkei was already under 20x earnings when it entered its long trading range, that greatly reduces the probability that the US can follow suit at its own far higher valuations prevalent today.

Sans these crucial Nikkei valuation metrics however, pure technical comparisons are quite shallow and not necessarily meaningful if trans-Pacific valuations happen not to be comparable.

And there are also profound differences between Japan and the US, both culturally and across the vastly different decades in which our respective busts played out. Since I was just discussing the probability of an extended US trading range in the August issue of our acclaimed Zeal Intelligence monthly newsletter for our subscribers, here is a quote dealing with a couple mega differences that simply must not be overlooked&

"Nevertheless, even though striking similarities exist, so do some amazingly profound differences. For example, in the 1990s the Japanese were the greatest nation of hardworking savers and exporters on Earth. The N225 trading range existed while Japan was exporting countless hundreds of billions of dollars of goods to the States as the US speculative manias in the 1990s fueled previously unthinkable levels of consumption."

"If we Americans hadn't been around last decade, fat and happy and greedily buying up everything in sight, would the Japanese bust experience have been different? Unlike Japan in the 1990s, today the US is sadly the greatest nation of debtors and importers on the planet. The US has relatively little heavy industry left, its balance of trade is massively negative, and Americans are leveraged to the hilt with the debt that financed all the gross excesses of the 1990s."

"While the 1990s were a decade when supplies were tight and factories ran 24/7 around the globe to meet primarily US demand, the 2000s are an ugly decade with a global bust. Even if the Americans did save and export, which we don't, who is left in the world to buy American products and lift up the US economy like the US economy did for the Japanese during their decade-long trading range?"

"Regardless of the pure technical price comparisons between the N225 and the SPX, I believe that any such comparisons must fully consider the vast differences between the US and Japan, and also between the different global economic environments of the 1990s and the 2000s. Will the US really happily follow the Japanese bust script?"

The rest of this current August issue of ZI goes on to discuss the prospects of a decade-long trading range in the States and why the probabilities seem to be conspiring against a similar decade in America. If you are interested in reading this letter, we are offering a complimentary copy of it to all e-mail PDF-edition new subscribers to Zeal Intelligence this month. Please consider joining us today!

While the index comparisons between the Japan and US busts are indeed provocative, many differences also exist which must be considered. In addition, in the absence of Japanese valuation data such as monthly Nikkei 225 P/E ratios and dividend yields, no true comparison can really be made. If we are blessed to secure that data that we have sought for so long, I will write another essay showcasing it and continue these fascinating Japan/US parallel-bust studies.

In the meantime though, please realize that while a massive long-term trading range is certainly possible in the US, it isn't probable. In addition, another decade of Great Bear grinding in America would do incalculable financial and psychological damage, probably far worse than a sharp and vicious plunge to a final low such as the early 1930s.

Long trading ranges are no picnic for investors!

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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