The Summer Of Our Discontent

The bear market in stocks around the world continues and is more than a year old. Declines of 20 percent from the peaks are child's play, with bourses in Europe off almost 30 percent and even bigger declines in some of the emerging-market darlings. The Asia emerging-country index has fallen 30 percent, and China's domestic markets are down 50 percent.

As always happens, the grim reapers are in full voice. George Soros speaks of a long period of wealth destruction, and many of my hedge-fund friends are profoundly pessimistic. Some say America will inevitably follow the course of Japan since 1990, with decades of stagnation and stock-market depression. It all calls to mind William Butler Yeats: "Things fall apart; the center cannot hold;/Mere anarchy is loosed upon the world."

The reference to Japan as a model for America's future is worth looking at. After a long, powerful bull market in equities, commercial and residential real estate and huge wealth creation, the Nikkei index crested at about 39,000 on Dec. 29, 1989. By then there had been wild speculation in stocks and real estate, and the Japanese were the wealthiest people in the world. They bought Rockefeller Center, Pebble Beach, most of the great art and many other toys.

When the bubble burst, the carnage was horrendous. The Nikkei collapsed 60 percent in two years, and in 2003 it reached 7,832—a staggering decline of almost 80 percent. Today the Nikkei is at 13,000, still off almost two thirds from its high. The Japanese economy has stagnated, and has been tortured by episodes of deflation. The Japanese banks that financed much of the craziness are still crippled and struggling. The bears argue that those who do not learn from history are doomed to repeat it.

But there are many differences between what happened in Japan in the early 1990s and the United States now. The size of the speculative bubble in Japan was far bigger relative to the size of the economy. By late 1989 the Nikkei index had soared 400 percent in just five and a half years. By any objective standard, valuations were outrageous, with the price-earnings ratio of the entire market at 70 times, and the price-to-book-value measure at more than five times. U.S. stocks today are at 12 and a half times earnings, and 24 times book value. The stock-market bust in Japan was also far more lethal than in the United States because of cross-holding by companies of other companies' shares (the zaitech craze, which was really just a fancy word for corporate gambling). When the stock market collapsed, the house of cards came down.

Japanese house prices in 1990 as a percentage of per capita GDP were 40 to 50 percent overvalued, while U.S. house prices on the same measure only became 15 percent overvalued as of July. Over the last 18 years, the Japanese banking system has been almost destroyed by bad loans. Japanese banks have had to write off a staggering 182 percent of their initial equity. So far U.S. banks have taken charges equivalent to 23 percent, and the most pessimistic forecasts are that eventually the write-offs and provisions will double that number.