Anatomy of a market crash : Tokyo in the 1990s

Anatomy of a market crash : Tokyo in the 1990s

The Japanese stock market of the late 1980s

If you like to study stock market booms and busts, the Japanese market of the late 1980s is a story without equal.

Over the past 25 years American stock prices have increased about six-fold. That's not bad, but the American market can't hold a candle to the Japanese stock market. During that same period Japanese stock prices increased nine times in Japanese yen, and over 30 times in US dollars.

So over time the Japanese stock market has done very well, but there was a giant bump along the way. I moved to Tokyo in the summer of 1987 and was in Japan during the 1987 worldwide stock market crash.

Tokyo rebounds quickly from 1987 crash

Fortunately, it turned out that the crash of 1987 wasn't the start of a new depression, and the world's major stock markets recovered fairly quickly from the crash.

But the Tokyo market recovered more quickly than other markets like London or New York. This early recovery encouraged many Japanese investors to buy stocks.

NTT privatization

The 1986 privatization of Nippon Telegraph and Telephone also helped to feed the stock buying frenzy.

NTT had been wholly owned by the government, but the government sold 10 percent of the company's shares to the public in one of the largest stock sales ever. This privatization brought millions of new investors into the stock market, and NTT shares rose substantially after the initial public offering.

There was only one problem with NTT. It was selling at a price earnings ratio of nearly 200!

PE ratios as indicators of value and growth

This P/E ratio of 200 was an incredible number. In the US, P/E ratios for most stocks have averaged about thirteen. In 1929, right before the crash, US stock P/E ratios were near 30. After the crash P/E ratios had dropped to 10 in 1932.

In the late 1960s, near a broad market top, price earnings ratios in America averaged about 23, while P/E ratios in the late 1970s were around 7. Currently, P/E ratios in the US are around 17.

Because a high P/E ratio means the stock offers a low earnings yield, you generally want to avoid stocks that have high P/E ratios. Still, a high P/E ratio might be justified.

If a company is growing rapidly, it means that its current earnings may be low, but it's future earnings may be high enough to justify the price of the stock.

In general, however, you should avoid stocks that have a P/E higher than their growth rate. If a company is growing at 30 percent a year, the company's P/E ratio should not be higher than 30.

Anyway, you could see that with a price earnings ratio of nearly 200, NTT was clearly overpriced. In no way was the saturated Japanese telephone business growing at 200 percent a year.

Entire Japanese market had a PE of 70

So, NTT was overpriced, but the entire Japanese stock market was overpriced. The average P/E ratio for Japanese stocks in 1989 was about 70.

But the country was in the grip of a mania. It seemed like everyone was investing in stocks. A number of my friends told me stories of how their family members were throwing money at stocks.

Another friend of mine wanted to buy a computer for the sole purpose of doing analysis so he could determine which stocks to buy. I told him, "Save your money. You don't need a computer to realize that a stodgy automobile company can't justify a P/E ratio of 80."

"But the Japanese market is different"

But he just shook his head and told me that a foreigner couldn't understand the Japanese stock market. It got so bad that my Japanese language teacher was telling me that it was a mistake to apply so-called American pricing models to Japanese stocks.

It happened at my nighttime Japanese language class while I was giving a presentation on the overvalued Japanese stock market.

The presentation was a good opportunity for me to work on my vocabulary related to finance, but it was a real eye opener regarding how far the mania had gone. In the middle of my presentation the instructor jumped up, interrupted me, and told the class that I was wrong.

The Japanese stock market isn't overpriced, she said, because, "Things are different over here." I don't claim to be able to time the market, but whenever you hear the phrase "Things are different over here", or "Things are different this time", you should start to get worried.

Why the Japanese market could justify higher P/Es

My instructor and other boosters of the Tokyo market did have a point. Because of accounting differences, Japanese companies had lower reported earnings than if they were using American accounting standards.

Also, interest rates in Japan at the time were lower than interest rates in America. Other things being equal, lower interest rates justify higher price earnings ratios.

Still, these details didn't justify the outrageous P/E ratios seen in Tokyo. Besides, in 1980 Japanese P/E ratios were only 20, and in 1985 Japanese P/E ratios were only 35. So the high P/Es seen in the late 1980s were an aberration, even for Japan.

Bank of Japan raises interest rates

Anyway the inevitable crash began in 1989 when one important prop that had been holding up the market began to crumble.

From 1987 until early 1989 the Bank of Japan had kept its official discount rate at a very low 2.5 percent. In the mid-1980s the yen had begun to rise rapidly against the dollar, and the Bank of Japan kept the rate low to try to prevent the economy from going into a recession because of the loss of exports.

Low interest rates prevented a recession, but the Bank of Japan kept rates too low, too long. By 1989 the economy was overheated. The economy, in certain quarters, was growing at 10 percent annually, and there were two job openings for every job seeker.

To me it was obvious that the economy was growing too quickly and inflation was a real threat. You could feel it. It seemed like all of my friends were talking about quitting their current job so they could get a big pay raise with a new company.