Rogue Missives - A Bubble Economy? by Jim Surowiecki

Rogue Missives

ROGUE ARCHIVES

Thursday, January 23, 1997

A Bubble Economy?
by Jim Surowiecki (Surowiecki)
When market watchers want to convey the full measure of their discomfort with the recent steady rise in the U.S. stock market, they are almost guaranteed to invoke the experience of the Japanese in the 1990s. The devastating and precipitous drops in the Nikkei index (the Japanese equivalent of the S&P 500) which occurred in 1990 and then again in 1992 and 1993 are taken as evidence that booms cannot last forever. Eventually, speculation is punished. The bubble has to burst.
The collapse of the Japanese stock market, and with it the Japanese real estate market, was shocking enough and dramatic enough to give anyone pause. And the impact of that collapse on the "real" Japanese economy was real indeed. Japan has spent much of the 1990s in recession, beset by persistent deflationary pressures that have torn at the country's social fabric and disrupted its remarkably successful fashioning of a kind of corporatist capitalism. Yet very few people in Japan in the late 1980s saw this coming. They did not understand that they were caught in a speculative frenzy until it was too late.
Even outside observers, whom one might have thought would have had a better perspective, were willing to dismiss whatever concerns they may have had about the bidding up of Japanese stocks in the face of the Nikkei's seventeen-fold rise between 1966 and 1988. John Templeton, for example, made enormous amounts of money for his fund's investors by going heavily into the Japanese market as early as the 1970s and staying in during the boom of the 1980s. The deluge of American press accounts of the rise of Japanese economic supremacy, many of which took the paper wealth generated by the Bubble Economy as permanent, took the Nikkei and real-estate rises as evidence that things had fundamentally changed in the world economy.
Even Peter Lynch, in his classic One Up on Wall Street, which was published just before the 1990 crash, tentatively bought into the idea that this was more than simply another tulip craze. "The total market value of all Japanese stocks actually passed that of U.S. stocks in April, 1987," he wrote, "and the gap has widened since. The Japanese have their own way of thinking about stocks, and I don't understand it yet. Every time I go over there to study the situation, I conclude that all the stocks are grossly overpriced, but they keep going higher, anyway."
As it happened, of course, Lynch was right about the stocks being overpriced. But then, anyone who had really been willing to wager on that in 1989 could have positioned himself or herself to make an enormous amount of money. The fact that so few did testifies to the hold that a bull market can have on people's minds. It's hard not to feel when things are going well that it'll last forever, that there always will be buyers. If Americans can adjust to a market P/E ratio of more than 20, why couldn't the Japanese adjust to a market P/E of more than 100, which is where the Nikkei was at one point?
Actually, insofar as things like P/E ratios are historically determined and therefore subject to change, Lynch's idea that there was a distinctive Japanese way of "thinking about stocks" contains the kernel of an interesting idea. There's no reason, after all, to see the 13 to 17 market P/E ratio as set in stone. If the underlying conditions of the economy as a whole or of investing as a whole change, then it makes sense to value stocks differently, and it makes sense that the market as a whole would value them differently. The problem with what happened with the Nikkei, though, and the reason it's such a poor analogy to the current U.S. market, is that what happened had nothing to do with the valuation of companies and everything to do with the speculative spiraling of credit, and with the Japanese state's unwillingness to allow the index to drop when it needed to drop.
The Japanese did not have a different way of thinking about stocks, if by that we mean that they had attained a consensus about valuation that was different from our own. (Not that there is one universal American method of valuation, either.) Instead, what was visible in the rise and fall of the Nikkei is an almost picture-perfect portrait of the separation of money from production, an uncanny demonstration of the basic illusions upon which any system of exchange is founded.
The Nikkei reached more than 35,000 because, in the end, an item -- in this case, a stock share -- is worth what someone else will pay for it, regardless of its 'underlying value.' And shares became more and more valuable because the nature of credit means that paper wealth today can be easily turned into more and more wealth -- paper and otherwise -- tomorrow. If you can borrow against your stock gains and acquire land -- which is what happened throughout the 1980s -- then the price of land will rise precipitously as well. And if you can borrow against your land holdings, which are inflated in price, and buy more stock, then the price of stock will continue to rise. It's a perfect closed system, until enough people decide that it's a system founded on air.
The possibility of that decision exists in any system of exchange. If tomorrow, investors woke up and decided that no high-growth company should be valued at more than 45 times earnings, there would be a lot of computer stocks that would fall through the floor. We want to draw as tight a connection as possible between the price of a company's shares and its "real" value. But how do we know what a company's real value is, and how do we separate that from its value in the eyes of others?
It's for those reasons that market observers caution against bullish hysteria, and for that reason that they tend to talk about this American market being so overvalued. Speculative crazes do happen. And the fact that more and more young people are entering investing today makes analogies to Japan all the more congenial for the bears, since the 1980s in Japan were characterized by the presence of the shin-jen rei, the young stock buyers who imagined that the future was ever-bright. But analogies exist only in the eye of the beholder, and this particular analogy rests upon a willful neglect of the dramatic difference in the conditions that prevailed in Japan in the late 1980s and the U.S. today.
The rise of the Nikkei in the 1980s was unaccompanied by any serious improvement in the fundamentals of the Japanese economy. While the Nikkei trekked above 35,000, economic growth in Japan, which had averaged close to a stunning 10% during the postwar period, began to slow, as Japan made the transition to a mature economy. While the Japanese continued to dominate export industries, the strictures on domestic consumption were perhaps already beginning to exact a toll on corporate profits. The point is not that the Japanese economy was weak while the Nikkei was strong -- far from it. Still, expectations of what Japanese corporations were going to be able to accomplish could not justify an ever-booming stock market.
The problem was that the Japanese state and the Japanese financial establishment had enormous amounts of political and cultural capital invested in an ever-rising Nikkei, and as a result, literally refused to allow it to find what one might crudely call a more natural level. Something like 70 percent of all shares on the Nikkei were held by other companies, and given the generally tightly interlocking nature of Japanese business, that meant that prices could be kept up. At the same time, the state gave specific instructions to public funds to invest in the Nikkei, which set a floor that helped drive prices up. Indeed, even after the 1990 and 1992 crashes, when the Nikkei ended up 60 percent below its all-time high, this kind of intervention, combined with foreign money, helped re-inflate the market before the bubble burst once more.
The proximate cause of the bubble bursting was, at least in part, the introduction of futures trading on the Nikkei on the Singapore Stock Exchange (Simex), of all places. Warren Buffett has said that stock futures and options should be outlawed, and it's not really clear what they contribute to long-term investing. In the case of Japan, what they contributed was a chance to gamble against the boom, which, in a sense, was a chance to make Japanese investors step back and look at how out of control they had gotten. Since the boom had been built on credit, with paper gains in one area (stock) leveraging gains in another (real estate) and vice versa, once the bust began a bad-debt spiral began that continues, to a some degree, today.
The Nikkei may, in fact, still be overvalued, as many American critics are now fond of saying. It does seem a mistake to apply American P/E standards to that market, just as it is a mistake to apply the prevailing P/E ratios of the American 1970s to the dramatically different American economy of today. But at the same time it's hard to know how to value companies in a deflationary economy. And the future of Japanese business remains cloudy, if only because it's not clear how true these companies will remain to their vision of capital investment and loyalty to their employees.
The deeper point, though, is that the story of what happened to the Nikkei cannot be separated from the specific conditions of the Japanese economy in the 1980s and from the incestuous manner in which the Nikkei was run. Nor can one simply overlook the degree to which the rise in the Nikkei was driven by a credit spiral for which there is no real parallel in today's bull market. The Nikkei was an example of speculation gone astray. It was an expression of the wildness that lurks at the heart of any arrangement like a stock market. But it offers no assistance at all to those interested in figuring out where this American bull market is going.
Bearish observers point to the fact that mutual fund investing has played a huge role in driving up the Dow over the past two years, and express skepticism that this new money will prove able to last through a serious market downturn. Against those who say that mutual fund investors, most of whom are saving for retirements that are still twenty or thirty years away, will be less inclined to panic and run, the bears point to the fact that 91% of mutual fund investors in Japan redeemed their investments during and after the crash. If the Japanese, who would seem to be stereotypically sticky about investing, couldn't hold, why should we expect Americans to hold?
Here, once more, an entire understanding of the stock market is built on one similarity, namely that there are mutual fund investors in Japan and in the United States. American mutual fund investors have entered the market at a time when U.S. corporations are reaping the benefits of a long period of restructuring that made them much better able to compete in an increasingly ruthless business climate. And they have entered the market at a time when those corporations are enjoying remarkably congenial global business conditions. At the same time, there's little or no evidence that these investors are using their stock gains to leverage other investments. In fact, while most Americans have added to their debt burdens over the last three years, the top 20% of income-earners have actually reduced their debt. This is a long way from the 1980s in Japan, when high rates of saving were accompanied by high levels of debt.
It's easier for market observers to rely on analogies than it is to recognize the historically specific nature of any given market. It's also easier for bears to point to past speculative frenzies than it is to investigate the reasons why those frenzies occurred. What the analogy with the Nikkei tells us is nothing more than that overvaluation can occur, and that houses of cards eventually fall. This is a different market, a different kind of boom, and, more importantly, a different economy. Tokyo in 1990 is simply not New York in 1997.
-- Jim Surowiecki (Surowiecki)

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ROGUE ARCHIVES

Thursday, January 23, 1997
A Bubble Economy? by Jim Surowiecki (Surowiecki) When market watchers want to convey the full measure of their discomfort with the recent steady rise in the U.S. stock market, they are almost guaranteed to invoke the experience of the Japanese in the 1990s. The devastating and precipitous drops in the Nikkei index (the Japanese equivalent of the S&P 500) which occurred in 1990 and then again in 1992 and 1993 are taken as evidence that booms cannot last forever. Eventually, speculation is punished. The bubble has to burst. The collapse of the Japanese stock market, and with it the Japanese real estate market, was shocking enough and dramatic enough to give anyone pause. And the impact of that collapse on the "real" Japanese economy was real indeed. Japan has spent much of the 1990s in recession, beset by persistent deflationary pressures that have torn at the country's social fabric and disrupted its remarkably successful fashioning of a kind of corporatist capitalism. Yet very few people in Japan in the late 1980s saw this coming. They did not understand that they were caught in a speculative frenzy until it was too late. Even outside observers, whom one might have thought would have had a better perspective, were willing to dismiss whatever concerns they may have had about the bidding up of Japanese stocks in the face of the Nikkei's seventeen-fold rise between 1966 and 1988. John Templeton, for example, made enormous amounts of money for his fund's investors by going heavily into the Japanese market as early as the 1970s and staying in during the boom of the 1980s. The deluge of American press accounts of the rise of Japanese economic supremacy, many of which took the paper wealth generated by the Bubble Economy as permanent, took the Nikkei and real-estate rises as evidence that things had fundamentally changed in the world economy. Even Peter Lynch, in his classic One Up on Wall Street, which was published just before the 1990 crash, tentatively bought into the idea that this was more than simply another tulip craze. "The total market value of all Japanese stocks actually passed that of U.S. stocks in April, 1987," he wrote, "and the gap has widened since. The Japanese have their own way of thinking about stocks, and I don't understand it yet. Every time I go over there to study the situation, I conclude that all the stocks are grossly overpriced, but they keep going higher, anyway." As it happened, of course, Lynch was right about the stocks being overpriced. But then, anyone who had really been willing to wager on that in 1989 could have positioned himself or herself to make an enormous amount of money. The fact that so few did testifies to the hold that a bull market can have on people's minds. It's hard not to feel when things are going well that it'll last forever, that there always will be buyers. If Americans can adjust to a market P/E ratio of more than 20, why couldn't the Japanese adjust to a market P/E of more than 100, which is where the Nikkei was at one point? Actually, insofar as things like P/E ratios are historically determined and therefore subject to change, Lynch's idea that there was a distinctive Japanese way of "thinking about stocks" contains the kernel of an interesting idea. There's no reason, after all, to see the 13 to 17 market P/E ratio as set in stone. If the underlying conditions of the economy as a whole or of investing as a whole change, then it makes sense to value stocks differently, and it makes sense that the market as a whole would value them differently. The problem with what happened with the Nikkei, though, and the reason it's such a poor analogy to the current U.S. market, is that what happened had nothing to do with the valuation of companies and everything to do with the speculative spiraling of credit, and with the Japanese state's unwillingness to allow the index to drop when it needed to drop. The Japanese did not have a different way of thinking about stocks, if by that we mean that they had attained a consensus about valuation that was different from our own. (Not that there is one universal American method of valuation, either.) Instead, what was visible in the rise and fall of the Nikkei is an almost picture-perfect portrait of the separation of money from production, an uncanny demonstration of the basic illusions upon which any system of exchange is founded. The Nikkei reached more than 35,000 because, in the end, an item -- in this case, a stock share -- is worth what someone else will pay for it, regardless of its 'underlying value.' And shares became more and more valuable because the nature of credit means that paper wealth today can be easily turned into more and more wealth -- paper and otherwise -- tomorrow. If you can borrow against your stock gains and acquire land -- which is what happened throughout the 1980s -- then the price of land will rise precipitously as well. And if you can borrow against your land holdings, which are inflated in price, and buy more stock, then the price of stock will continue to rise. It's a perfect closed system, until enough people decide that it's a system founded on air. The possibility of that decision exists in any system of exchange. If tomorrow, investors woke up and decided that no high-growth company should be valued at more than 45 times earnings, there would be a lot of computer stocks that would fall through the floor. We want to draw as tight a connection as possible between the price of a company's shares and its "real" value. But how do we know what a company's real value is, and how do we separate that from its value in the eyes of others? It's for those reasons that market observers caution against bullish hysteria, and for that reason that they tend to talk about this American market being so overvalued. Speculative crazes do happen. And the fact that more and more young people are entering investing today makes analogies to Japan all the more congenial for the bears, since the 1980s in Japan were characterized by the presence of the shin-jen rei, the young stock buyers who imagined that the future was ever-bright. But analogies exist only in the eye of the beholder, and this particular analogy rests upon a willful neglect of the dramatic difference in the conditions that prevailed in Japan in the late 1980s and the U.S. today. The rise of the Nikkei in the 1980s was unaccompanied by any serious improvement in the fundamentals of the Japanese economy. While the Nikkei trekked above 35,000, economic growth in Japan, which had averaged close to a stunning 10% during the postwar period, began to slow, as Japan made the transition to a mature economy. While the Japanese continued to dominate export industries, the strictures on domestic consumption were perhaps already beginning to exact a toll on corporate profits. The point is not that the Japanese economy was weak while the Nikkei was strong -- far from it. Still, expectations of what Japanese corporations were going to be able to accomplish could not justify an ever-booming stock market. The problem was that the Japanese state and the Japanese financial establishment had enormous amounts of political and cultural capital invested in an ever-rising Nikkei, and as a result, literally refused to allow it to find what one might crudely call a more natural level. Something like 70 percent of all shares on the Nikkei were held by other companies, and given the generally tightly interlocking nature of Japanese business, that meant that prices could be kept up. At the same time, the state gave specific instructions to public funds to invest in the Nikkei, which set a floor that helped drive prices up. Indeed, even after the 1990 and 1992 crashes, when the Nikkei ended up 60 percent below its all-time high, this kind of intervention, combined with foreign money, helped re-inflate the market before the bubble burst once more. The proximate cause of the bubble bursting was, at least in part, the introduction of futures trading on the Nikkei on the Singapore Stock Exchange (Simex), of all places. Warren Buffett has said that stock futures and options should be outlawed, and it's not really clear what they contribute to long-term investing. In the case of Japan, what they contributed was a chance to gamble against the boom, which, in a sense, was a chance to make Japanese investors step back and look at how out of control they had gotten. Since the boom had been built on credit, with paper gains in one area (stock) leveraging gains in another (real estate) and vice versa, once the bust began a bad-debt spiral began that continues, to a some degree, today. The Nikkei may, in fact, still be overvalued, as many American critics are now fond of saying. It does seem a mistake to apply American P/E standards to that market, just as it is a mistake to apply the prevailing P/E ratios of the American 1970s to the dramatically different American economy of today. But at the same time it's hard to know how to value companies in a deflationary economy. And the future of Japanese business remains cloudy, if only because it's not clear how true these companies will remain to their vision of capital investment and loyalty to their employees. The deeper point, though, is that the story of what happened to the Nikkei cannot be separated from the specific conditions of the Japanese economy in the 1980s and from the incestuous manner in which the Nikkei was run. Nor can one simply overlook the degree to which the rise in the Nikkei was driven by a credit spiral for which there is no real parallel in today's bull market. The Nikkei was an example of speculation gone astray. It was an expression of the wildness that lurks at the heart of any arrangement like a stock market. But it offers no assistance at all to those interested in figuring out where this American bull market is going. Bearish observers point to the fact that mutual fund investing has played a huge role in driving up the Dow over the past two years, and express skepticism that this new money will prove able to last through a serious market downturn. Against those who say that mutual fund investors, most of whom are saving for retirements that are still twenty or thirty years away, will be less inclined to panic and run, the bears point to the fact that 91% of mutual fund investors in Japan redeemed their investments during and after the crash. If the Japanese, who would seem to be stereotypically sticky about investing, couldn't hold, why should we expect Americans to hold? Here, once more, an entire understanding of the stock market is built on one similarity, namely that there are mutual fund investors in Japan and in the United States. American mutual fund investors have entered the market at a time when U.S. corporations are reaping the benefits of a long period of restructuring that made them much better able to compete in an increasingly ruthless business climate. And they have entered the market at a time when those corporations are enjoying remarkably congenial global business conditions. At the same time, there's little or no evidence that these investors are using their stock gains to leverage other investments. In fact, while most Americans have added to their debt burdens over the last three years, the top 20% of income-earners have actually reduced their debt. This is a long way from the 1980s in Japan, when high rates of saving were accompanied by high levels of debt. It's easier for market observers to rely on analogies than it is to recognize the historically specific nature of any given market. It's also easier for bears to point to past speculative frenzies than it is to investigate the reasons why those frenzies occurred. What the analogy with the Nikkei tells us is nothing more than that overvaluation can occur, and that houses of cards eventually fall. This is a different market, a different kind of boom, and, more importantly, a different economy. Tokyo in 1990 is simply not New York in 1997. -- Jim Surowiecki (Surowiecki)