This year sees the 30-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 stockmarket bubbles of all time peaked on the last trading day of the year when Japan’s Nikkei 225 index hit 38,915.
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 halved in nine months. That was just the start of Japan’s long journey into the shadow world of deflationary stagnation and financial crisis. When Shinzo Abe became prime minister for the second time, in late 2012, the index was still languishing below 9,000, less than a quarter of its peak.
Since then the Japanese market has outperformed 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 30 years on. In comparison, it took America’s Dow Jones Industrial Average 25 years to break through its pre-Wall Street Crash high of 1929 and it has subsequently never looked back.
A Godzilla-like boom-bust cycle
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/earnings (p/e) ratio of 70 times and offered a microscopic dividend yield of 0.5%. American stocks on the eve of Black Thursday in October 1929 were trading at a p/e of 20 times and offered a dividend yield of 3% – elevated by previous standards, but not absurdly so.
Not only was the overvaluation of Japanese stocks far more extreme, but an even larger real-estate bubble 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 World War II.
So what’s next? Encouragingly, the p/e ratio of the Japanese market is now at its lowest level in 48 years. The dividend yield of 2.5% is solid enough, and Japanese companies are 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 sceptical and cautious. In other words, stockmarket conditions in Japan today are the polar opposite of what confronted investors in 1989.
Japan’s uncertain outlook
Certainly, risks abound. Deflationary forces are still powerful. A high-tech trade war would hurt all of East Asia, Japan included. 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. 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 – drag the country back down into inertia?
Japanese stock prices need to nearly double from here to clear the 1989 peak. In the box, I look at three simplified scenarios of how that could happen, using different growth projections and prospective valuations. Calculations are based on the Topix index, which is more representative than the Nikkei. The valuation metric used is the price-to-book ratio, which is less volatile than earnings-based measures.
Three scenarios for Japanese stocks
Scenario 1: Governance-driven restructuring.
Shareholder-friendly boards drive a wave of mergers, spin-offs and tie-ups, supported by easy monetary and fiscal policy. Earnings-per-share grow by 8% per year, of which 3% comes from share buybacks. Valuation rises to 15-year average. Year of new stockmarket high: 2026
Scenario 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% per year, with 2% from buybacks. Year of new stockmarket high: 2032
Scenario 3. Back to stagnation.
Deflationists and fiscal hawks reverse Abenomics. Nominal GDP sinks while corporations hoard cash. Earnings-per-share decline at 1% per year, with no buybacks. Valuation slides back to 2012 lows.Year of new stockmarket high: 2045
The reality is likely to be far messier than these scenarios suggest, but it is clear that for the overall market to produce high returns, the stocks of average companies must do well. That requires decent growth in the world economy and no fiscal austerity or monetary mistakes at home. Corporate-governance reforms must continue and boards need to mandate change at serial underperformers.
Generating higher profit margins – as listed Japanese firms are now doing – is a necessary, but not sufficient, condition. In order to maintain a good return on shareholders’ equity, growth in earnings-per-share must exceed growth in shareholders’ equity. In a low-growth environment, that can only be done by increasing pay-outs to shareholders via dividends or buybacks.
For more Japan commentary from Peter Tasker, see petertasker.asia