More Than A Bear Rally

The majority of the financial commentariat thinks that the run-up in stocks over the past few weeks is merely a bear-market rally. After all, headwinds to growth in the United States remain fierce, with credit troubles still sprouting like weeds. The prophets of doom are extrapolating the sharp fall in home prices over the past year to make the claim that the downturn in the U.S. housing sector is the worst since the Great Depression. Given the high levels of indebtedness, the consumer cannot withstand such a meaningful decline in net worth; in short, the bears find it easy to make the case that the United States is going the way of Japan—a parallel that spooks many investors, as it symbolizes a dark economic age.

But as that saw goes: history repeats itself only for those who don't know the details. Even if the Japan analogy holds some validity, the bears are focusing on the wrong time period in the 1990s and then exaggerating the negative effects for the rest of the world arising from the relative decline of one major economic power.

For starters, at the peak of the bubble in December 1989, Japan's stock market was trading at an extravagant price-to-earnings, or PE, ratio of 55. From that dizzying height, Japanese stocks subsequently fell more than 60 percent over the next three years, as economic growth collapsed from more than 5 percent to less than 2 percent. Policymakers took no steps to stem the rot until late in 1991.

In contrast to the Japan of 1989, the U.S. stock market never experienced bubblelike conditions; valuations peaked in October 2007 with a PE ratio of 15. With many pundits writing alarmist literature for so long on the overspent and undersaved U.S. consumer, investors were always skeptical about the strength of the largely debtfinanced U.S. housing boom. They never accorded high valuations to the home-building and financial sectors, despite strong earnings growth in those areas of the economy. The relatively low valuations explain why the U.S. stock market has been surprisingly resilient of late despite all the dire news. Policymakers have also been much more proactive than their Japanese counterparts in dealing with the credit and housing woes. While easier monetary policy cannot artificially pump growth higher, it can elongate the deleveraging cycle by amortizing the pain over time.

The latest GDP growth numbers show the United States may even be able to avoid an outright recession, just as Japan's economy dodged an extended period of negative growth for much of the 1990s. The period perhaps most comparable to the U.S. situation today came between 1992 and the Asian financial crisis in 1997. During this period Japanese policymakers took aggressive steps on both the fiscal and monetary fronts to cushion the economy from a deflationary shock, and strong export growth helped the economy expand at an average 1.5 percent. The Japanese stock market traded mostly sideways, with the Nikkei oscillating between 14,000 and 21,000, rising to the top end of that range when global growth was strong and hitting the lower limit when the external environment turned unfavorable.

Similarly, helped by exports, the U.S. economy could expand at an average 1 to 1.5 percent over the next few quarters, while domestic consumers gradually work down their debt burden. That's subpar growth, but still a far cry from the Armageddon scenario that many deemed plausible just a few weeks ago. The U.S. stock market could—like the Nikkei in the 1992-97 period—remain locked in an extended trading range between 1250 (the low point, hit in March this year) and 1550 (the high, reached in October last year), with global growth determining the swings between these limits. Overseas operations already account for 40 percent of the U.S. stock market's earnings, a number similar to that of the Japanese market.