September 20, 2006

The Great Decline

by Wynn Quon

This is the story of an economic superpower. After two decades of innovation and strong economic growth, times were good. The jobless rate was the lowest in memory. The nation’s expertise in applying new technologies was unequalled. But self-confidence had started to change into complacency. Success and wealth were no longer goals to be aggressively strived for. Instead they were considered birthrights. And the new road to riches was as old as the Tulipmania. By borrowing more and more money, its citizens gradually created a world of make-believe where it seemed that everyone could get rich. Gross consumer debt exploded, rising seven-fold in a decade. Low interest rates fuelled widespread recklessness. Why settle for a measly 1 or 2% return when you could get ten times that, buying stocks or real-estate? Why, indeed. Investors jumped into real estate and the number of paper millionaires soared.

Some of you may think I'm talking about America in 2006. I'm not. This is Japan in the 1980s. But what happened then holds a warning of things to come for us in North America.

How did Japan’s story end? As the bubble inflated, those who urged caution were ignored. There is no insanity so dangerous as the belief in never-ending profit. While this type of insanity always proves temporary and short, the tragic aftermath is severe and long-lasting. In 1990 interest rates in Japan rose and the stock market and real estate bubble, inflated beyond reason, collapsed. On December 31, 1989, the Nikkei stock market index almost reached 40,000. It would not reach that level again. The stock market plunged 50% in less than a year. Three years later, it was down to 14,310, a decline of 63%. Property prices crashed and the Japanese miracle began to unravel in earnest. When prices were rising, and debt flowed freely, no one paid much attention to the credit-worthiness of their borrowers. But now as prices plummeted, that negligence came home to roost as overextended investors were forced into bankruptcy.

The punishment for the excesses of the eighties was biblical in its magnitude. Just as Japan's speculative bubble echoed the excesses of the Roaring Twenties, the aftermath recalled the implosion of the Great Depression of the Thirties. There was the same sad picture of panic-stricken depositors fighting to get money out of insolvent banks. The Japanese government tried to hold the line with bailouts and emergency financing but the deluge of defaulting debt was too much. Hyogo Bank was the first to fail, followed by Hanwa Bank, followed by Hokkaido Takushoku Bank, Japan's tenth largest. Stock brokerages also fell. The most notable was Yamaichi Securities, a hundred-year old firm that was one of the four biggest in the country.

Japanese retirees who were looking forward to a comfortable retirement in their senior years faced an ice-cold reality. The cheerful consensus that stocks would always be the best investment over the long-term was being tested to its limit. And today seventeen years later, with the Nikkei barely above 16,000, that consensus has failed its most stalwart supporters.

What does all this have to do with us? My answer should not come as a surprise: The bubble that led to Japan’s financial disaster is replaying itself today in America:

  • Stock market margin debt, the amount of money investors have borrowed to buy stocks, has reached US$230 billion.
  • Households accumulated US$1.33 trillion in net new debt during the first quarter of 2006. The expansion in new borrowing outpaced the rise in disposable income according to the Federal Reserve.
  • The ratio of household debt (US$11.84 trillion) to total household assets (US$66.03 trillion) is at record levels. The problem is that debt can only be reduced through repayment while household asset values (i.e. house and stock prices) can fall of their own accord.
  • An ordinary 1800 square foot home located an hour outside San Francisco sells for US$800,000 (and that’s considered cheap).
  • In a replay of the financial negligence that gripped Japan in the eighties, American banks are peddling so-called “negative equity”, or “option adjustable rate mortgages”. Can’t afford a $600,000 mortgage? No problem. The bank can set you up with a monthly payment that doesn’t cover the interest on your loan. Instead, the shortfall is added to your principal. According to Businessweek, more than 1.3 million clueless borrowers have taken out US$466 billion worth of these mortgages in the past two years. Only in a bubble would lending large sums of money to people who can’t pay it back seem like a good idea.
  • The Bush administration continues to run enormous deficits, shattering records four years in a row. The US federal debt passed US$7 trillion in 2004. Less than two years after, it now stands at US$8.55 trillion.

The danger signs are already clear. American housing sales have slowed dramatically and inventories are at 13-year highs. House prices have started weakening in some of the hotter real-estate markets. With interest rates at two-year highs, the pain is only just beginning. Remember the US$11.84 trillion dollars of household debt that Americans are carrying against US$66.03 trillion of assets? When house prices and stocks start to fall, the value of assets will plummet but that mountain of debt must still be paid back. To avoid default, consumers will drastically cut back spending…which in turn accelerates the slowdown. This is the vicious circle that defines what happens after every speculative mania.

The big difference between the Japanese bubble and the American bubble was that Japan’s financial disaster was largely confined to that country. We won’t be so lucky when the American bubble bursts. A severe American downturn will have a brutal impact on the global economy. As our largest trading partner, Canada will be one of the first to feel the pain. China’s export-driven sectors will be hit hard. Worse, China’s go-go economy has its share of lax financial practices and dangerous debt. A slowdown in American demand for its exports could trigger a replay of the Asian economic crisis of the late 1990s.

How will the markets react? If we see a repeat of the Nikkei experience on American stock markets, the Dow could fall from its current level of 11,400 to 3,800. Real estate values in California and Florida could be reduced by half. Gold stocks will fall at first with the general stock market but then later as bankruptcies start to snowball and companies default on their bonds, the price of gold will soar.

There is a real chance of a panic on Wall Street. The last major crash happened in 1987 when stocks dropped 22% in a single day. Many of today’s traders and brokers have never experienced a major bear market. By Santayana’s principle, the conditions may be ripe once again for some truly fearsome days. An equivalent drop today would mean a loss of almost 2500 points. What could make a panic even worse is that we’ve never had a Crash in the Internet Age. The Net’s ability to propagate rumor and fear could make things quite ugly.

In light of the perilous times ahead what is one to do? First, be fiscally conservative. How much debt you are carrying will determine how well you ride out the approaching hard times. Don’t let a well-paying job lull you into thinking you can carry a high debt load. In a severe downturn, unemployment will hit double digits. Second be sure that you can absorb losses in your stock portfolio without panicking. This means figuring out ahead of time what your comfort level is. Warren Buffett has long advised that stockholders should always be prepared for a 50% drop in share prices. Unfortunately many investors ignore this and put too much of their wealth into stocks during bull markets only to end up selling in fear during bear markets.

I expect that the following investment vehicles will do exceptionally poorly:

  • Resource stocks. Despite what you’ve heard about peak oil, I think we’re more likely to see oil at $30/barrel rather than $100/barrel.
  • High-multiple technology stocks (e.g. Google) rely on a continuing robust economy to prop up their share prices. Look out when these companies disappoint on the earnings front. It’s a long way down to rational valuation.
  • Banks who have high exposure to ARMs and that have a lending base in areas where real-estate speculation is worst (e.g. California and Florida). Examples include Countrywide Financial Corporation (NYSE: CFC), FirstFed Financial Corporation(NYSE: FED). Sophisticated investors may try playing with put options on these companies.
  • The US dollar.

The bottom line is that prudence always arrives for the speculative crowd. But only in hindsight, when it is least useful.

Wynn Quon is chief investment analyst at Legado Associates (e-mail). An electronic copy of this article is available at