Stocks for the looong run: Could Japan’s lost decades happen in America?

The Nikkei is trading at 26 times earnings—about in line with the S&P 500. Instead of being hyped as the next economic superpower, the current bull market is being driven partly by improved corporate governance. (Photo: AP)
The Nikkei is trading at 26 times earnings—about in line with the S&P 500. Instead of being hyped as the next economic superpower, the current bull market is being driven partly by improved corporate governance. (Photo: AP)

Summary

Tokyo’s market has almost broken even after 34 years, pointing to the dangers of extreme bubbles.

America’s stocks are making new highs and the U.S. economy looks poised to stick a rarely seen soft landing. What could go wrong?

A lot, actually.

Stocks aren’t as expensive as they were two years ago, but are still pricey compared with their prepandemic 10-year average. Some of the so-called Magnificent Seven tech stocks, in particular, have bold assumptions baked in.

To see what can happen when such optimism proves misplaced, look no further than Asia. Japan’s recently roaring Nikkei is within 8% of its record high of 38,957 last seen in December 1989, just before Japan’s bubble economy imploded. The Dow, which is coincidentally now around the same level, was below 7,000 back then. China is shaping up as, potentially, another cautionary tale: The MSCI China is trading well below where it sat in mid-2007.

The U.S. today is a very different place than boom-era Japan or China. But both should serve as obvious, painful counterexamples to the idea that “stocks always go up in the long run" or “it doesn’t matter when you buy." Sometimes, it does.

It doesn’t take a war or a pandemic to destroy market returns for long periods. Bad economic policymaking, weak demographics and toxic politics can be more than enough. Japan’s example is instructive.

Back in 1989, Japan was taking over the world. The country’s economy had grown 6.7% in 1988. Sony had just bought Columbia Pictures, one of the largest Hollywood studios, for $3.45 billion. Japanese property company Mitsubishi Estate took control of Rockefeller Center in New York City that October. When land prices peaked in Tokyo, Japan’s Imperial Palace grounds were more valuable than all the land in Florida. Then the Nikkei dropped about 60% in the first two years of the 1990s. Multiple comebacks have fizzled.

Some well-known Japanese companies have continued to do well, with their shares putting Japan’s “lost decades" behind them. Walkmans aren’t a thing any more, but Sony’s PlayStations have been a massive success. Likewise for Nintendo’s videogame consoles, and Toyota Motor is the world’s biggest carmaker by sales.

But some Japanese blue chips from the bubble era remain a shadow of what they were in the 1980s. Nippon Telegraph and Telephone was once the world’s largest company. Its stock price remains 40% below the shares’ peak in 1987. Nippon Steel, which hit headlines recently with its 1980s-esque acquisition of U.S. Steel, is valued at less than half what it was in 1989. Swept up in the frenzy, they never grew into those heady valuations. The average price-to-earnings ratio of companies listed on the Tokyo Stock Exchange’s first section was roughly 70 in 1989, according to data provider CEIC.

The level of froth in U.S. markets hasn’t reached nearly that level yet. There also isn’t an obvious parallel in the U.S. to Japan’s precrash real-estate bubble, which was a crucial factor behind the plunge.

In other ways, though, Japan’s example is more worrying. Its sclerotic politics helped prevent a more forceful economic response when the bubble did pop. Assumptions that Japanese technological leadership in important parts of the tech sector—especially chips and consumer electronics—would persist proved misguided. Rising automation helped offset Japan’s plummeting birth rate, but not nearly enough to put growth back near prebubble levels. And a deep aversion to meaningful immigration changes prevented Japan from accessing an obvious source of new vitality.

Sound familiar? One way to view the U.S. market rally—especially if actual growth slows this year and next, and earnings multiples keep rising—is a bet that U.S. technological leadership can continue to compensate for toxic politics and weakening demographics.

But if the productivity and profit boost from artificial intelligence, for example, proves to be overhyped, investors will probably be far less inclined to look past America’s other structural defects—especially weak population growth and heavy government debt.

Both Japan and China’s fondness for industrial policy, and Washington’s increasing inclination to follow suit, should be another red flag for U.S. stock bulls. Subsidizing specific industries to correct “externalities" such as climate change or threats to national security might sometimes be warranted. But it is far from clear that subsidies can boost growth over the long run. And it often turns out poorly for investors because, by industrial policy’s very nature, it tends to create overcapacity and depress companies’ pricing power. At the same time, efforts to build “supply security" usually raise costs.

In other words, Washington could entice companies to build many more chips and electric vehicles, but investors in Intel or Tesla might not end up thanking them—especially if overall demand for chips or electric vehicles is disappointing.

Meanwhile Japan is actually looking pretty good these days.

The Nikkei is trading at 26 times earnings—about in line with the S&P 500. Instead of being hyped as the next economic superpower, the current bull market is being driven partly by improved corporate governance—a key plank of the late former Prime Minister Shinzo Abe’s pro-market reforms. Companies are spending more on dividends and buybacks and tightening up their notoriously bloated balance sheets.

Activist investors have also been on the rise. Most notably, foreign investors ousted the chairman of stodgy electronics giant Toshiba in 2021. The iconic industrial company was eventually taken private by a group of domestic investors last year. And Japan is now the biggest market outside of the U.S. for Warren Buffett’s Berskshire Hathaway.

Finally, the exodus of investors from China—now suffering the consequences of its own economic missteps and demographic collapse—has given Japan another push. Needless to say, investors aren’t talking much about the so-called ATMs (Alibaba, Meituan and Tencent), once viewed as something like China’s Magnificent Seven, these days.

Maybe stocks do always go up in the long run—as long as you’re willing to wait 30 years.

Write to Jacky Wong at jacky.wong@wsj.com and Nathaniel Taplin at nathaniel.taplin@wsj.com

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