Published in Money Week 2/8/2019
This year sees the thirty year anniversaries of several major historical events, ranging from the Tiananmen Square massacre in Beijing to the fall of the Berlin Wall. In the world of investment too, an extraordinary event took place in 1989. One of the largest stock market bubbles of all time peaked on the last trading day of the year when Japan’s Nikkei Index hit 38,915.
Bubble Japan – disco fever
The term “bubble” was not in general use then, but by the end of 1990 it had won Japan’s annual prize for new word of the year. You can see why. The Nikkei Index halved in nine months and that was just the start of Japan’s long journey into the shadow world of deflationary stagnation and financial crisis.
When Prime Minister Shinzo Abe made his comeback in late 2012, the Index was still languishing below 9,000, less than a quarter of its peak value. Since then the Japanese market has done well, outperforming European markets, the emerging markets collectively and indeed most significant markets with the exception of the US.
Even so, the Nikkei remains far below its all-time high, which is an extraordinary phenomenon thirty years on. In comparison, it took the American Dow Jones Index 25 years to break through its pre-Wall Street Crash high of 1929 and it has subsequently never looked back.
The difference testifies to the Godzilla-like magnitude of Japan’s boom-bust cycle. At the peak in December 1989, Japanese stocks were trading at a price-to-earnings ratio of 70 times and offered a microscopic dividend yield of 0.5%. According to Professor Robert Shiller of Yale University, American stocks on the eve of “Black Thursday” in October 1929 were trading at a price-to-earnings ratio of 20 times and offered a dividend yield of 3% – elevated by previous standards, but not stratospherically so.
Bubble Japan – young salarymen thrust banknotes at blasé taxi drivers.
Not only was the overvaluation of Japanese stocks far more extreme, but an even larger real estate bubble, involving every category of land in the nation, had inflated at the same time. No wonder recovery has taken much longer. By some reckonings, the total amount of wealth destroyed in Japan’s bubble collapse was greater, in relation to the size of the economy, than the devastation wreaked by the Second World War.
So what’s next? Encouragingly, the price earnings ratio of the Japanese market is now at its lowest level in 48 years. The dividend yield of 2.5% is solid enough, but Japanese companies are currently returning almost the same amount again to shareholders through buying back their own shares. Thus, the overall “cash return yield” (dividends and buybacks together) is a handsome 5% plus. Meanwhile, sentiment is far from euphoric, with both companies and investors generally sceptical and cautious
In other words, stock market conditions in Japan today are the polar opposite of what confronted investors in 1989.
Certainly, risks abound. Deflationary forces are still powerful, as attested by the astonishingly low level of bond yields almost everywhere. A high-tech trade war would hurt all of East Asia, Japan included, and any kind of global dislocation, whether financial or geopolitical, could propel the yen-dollar rate into the 90s again.
Crucially, we do not know how the Japanese political landscape will develop from here. Prime Minister Shinzo Abe, under whose watch most of the positive developments have happened, is scheduled to leave office in 2021. Will he become an influence behind the scenes, overseeing the continuation of his policy agenda? Or will Japan’s real opposition – the bureaucracy – fill the power vacuum and drag Japan back down into inertia?
Japanese stock prices need to nearly double from here to clear the 1989 peak. That could happen in a few years’ time or in the far future, depending on how the confluence of factors plays out.
Here are three simplified scenarios of what could happen, using different growth projections and prospective valuations. Calculations are based on the Topix Index which measures the market capitalization of 2,140 Japanese stocks and is thus more representative than the Nikkei Index. The valuation metric used is the price-to-book ratio, which is less volatile than earnings based measures.
1. GOVERNANCE-DRIVEN RESTRUCTURING – increasingly shareholder-responsive boards drives a wave of M&A, spin-offs and tie-ups, supported by easy monetary and fiscal policy.
Earnings per share grows by 8% p.a., of which 3% comes from share buybacks. Valuation rises to 15 year average.
Year of new stock market high: 2026
2. MUDDLE THROUGH – profitability remains near current levels, but policy mistakes hurt top-line growth.
No change in valuation. Earnings per share grow by 5% p.a., with 2% from share buybacks
Year of new stock market high: 2032
3. BACK TO STAGNATION – deflationists and fiscal hawks reverse Abenomics. Nominal GDP sinks while corporates hoard cash.
Earnings per share decline at 1% p.a., with no share buybacks. Valuations slide back to 2012 lows.
Year of new stock market high: 2045
The reality is likely to be far messier and more confusing, but it is clear that for the market to produce high returns into the medium term, the stocks of average companies, not just a select group of “winners,” must do well.
That requires a number of conditions to be met. There must be decent growth in the world economy and no fiscal austerity or monetary mistakes at home. Equally important, corporate governance reforms must continue and boards need to be pro-active in mandating change at serial underperformers.
Generating record-high profit margins – as listed Japanese companies are now doing – is a necessary, but not sufficient condition for a buoyant stock market. In order to maintain a good level of return on shareholders’ equity (RoE), growth in earnings per share (R) must exceed growth in shareholders’ equity (E). In a low growth environment, that can only be done by increasing pay-outs to shareholders, via dividends or share buybacks, thus restraining E.
If that happens, the total return index (which includes dividends) will be a better measure of stock market health than an ordinary price index such as the Nikkei. On that basis new highs should come much sooner.