Japan’s Nikkei 225 is on the verge of surpassing its all-time highs of 1989, ending a 34-year drought for investors in the Land of the Rising Sun. That in itself is cause for celebration on the one hand but also a deeply flawed way of understanding how markets work – both in Japan and everywhere in the world.
Indeed, Japanese stock market participants are rejoicing as Japanese stocks have soared, with the Nikkei matching the S&P 500 in dollar terms, despite its relatively small exposure to the AI boom driving stock markets. USA.
However, there are good reasons to suggest that the party should stop here. And the truth is that in reality the atmosphere should be more like a funeral than a celebration.
What does history show?
- The Japanese stock market reached all-time highs on the last trading day of 1989. Since then the Nikkei has been in a relentless decline, slipping more than 80%. Investors crashed, with the Nikkei losing about as much—albeit over a longer period—as its predecessor the S&P 500 did from 1929 to 1933, during the Great Depression.
- It took the US market about 25 years to hit a new record high. Less obvious but more important is that media headline numbers don’t really matter much over long periods.
- The Nikkei, like the Dow Jones, is a terrible way to gauge the market. Index numbers do not include dividends received by investors. They don’t account for the devastating effect of inflation. And measuring returns from the top in the midst of the biggest bubble in history tells us little about the future.
The Nikkei is a flawed indicator
The Nikkei was first created in 1950 by the newspaper of the same name to calculate average stock prices. Therefore stocks that are priced higher have a greater impact than those whose valuation is lower.
This is silly, as the price of a stock is an arbitrary result of how many shares the company chooses to issue – and just like the Dow, it leads to strange results.
The Nikkei’s heaviest constituent is Fast Retailing, owner of fashion chain Uniqlo, which makes up almost 11%. Toyota Motor, the country’s most valuable company, accounts for 1.4%.
If you were to rank stocks by market capitalization, as other major indexes do, Fast Retailing would be under 2% of the range and the seventh largest component. This could be funny, except that, unlike the Dow, the Nikkei actually matters.
Futures contracts based on it are much more widely traded than those based on Topix. As a result, huge sums of money are moving on the basis of something that is not suitable for deciding how to allocate capital between companies.
If you were to use the Topix, instead of the Nikkei, stocks would be about 8% below their December 1989 levels. In other words, the celebrations of new all-time highs are a bit premature.
On the other hand, what is vitally important is the dividends. Over the long term, the compounding effect of dividend reinvestment makes a huge difference in returns.
Over the past half century, US stocks have turned $100 into $6,200 without dividends (ignoring costs and taxes), while with dividends they would be worth $25,000.
The same is true in Japan, where the 2% dividend yield is now much higher than in the US. An investor who made the decision to buy at the top of the bubble and reinvest dividends erased all losses by March 2021.
Inflation
Inflation is also very important. The good news for asset owners in Japan is this: because of deflation, which has lasted for about a decade and a half, goods have become cheaper. Thus, during this supposed “lost decade,” the value of their assets was not eroded by inflation, as was the case elsewhere.
The bad news is that yields were much higher everywhere else – even after inflation. Worse, pre- and post-lost-decade inflation has left the Nikkei (and Topix), excluding dividends, well below its 1989 record high.
Japanese investors didn’t have a strong currency — which is usually accompanied by deflation — to compensate: The country’s past decade of easing has weakened the yen and pushed it back to where it was at the height of the 1989 bubble.
The real reason to celebrate is psychological, as Japan shakes off the bubble hangover. Forget the nominal value of a flawed indicator and see the real changes in the country. Time has been a healer, allowing Japan’s banks to rebuild, companies to weather the wild overinvestment of the 1980s, and consumers to overcome the deflationary mindset of ever-lower prices and stagnant wages that resulted.
Valuations also fell. The private sector has recovered and while public debt remains very high (most of Japan’s public debt is owned by the Japanese anyway), Japanese companies are much more attractive. This is success.
