The ongoing global stock market rally has lifted Japanese stocks to their highest level in 25 years. Put another way, if you'd bought the Japanese index a quarter of a century ago – and that may have seemed a savvy move at the time, given the Nikkei had fallen by more than 40 per cent from its 1989 high three years earlier – you'd only be breaking even now. For investors, it's the stuff of nightmares, a scary counterpoint to the oft-repeated argument that stocks are invariably the best long-term investment. Does the Japanese experience offer lessons for long-term investors? Or is Japan a freak case, an anomaly, an extreme crash that is the exception to the "buy and hold" rule?
Certainly, the Japanese crash has been extreme. Typically, stocks recover after even the worst of crashes. The US stock market more than halved between October 2007 and March 2009, in what was the biggest crash since the 1930s Depression. However, anyone who held on tight has done just fine. Including dividends, the S&P 500 has more than doubled over the past 10 years.
Global stocks suffered their biggest one-day fall in history on Black Monday in October 1987, but regained their pre-crash heights within two years.
The UK stock market suffered a particularly vicious bear market in 1973-74, losing almost three-quarters of its value, but investors nevertheless recouped their losses within three years. In contrast, Japan’s Nikkei remains some 40 per cent shy of 1989’s all-time high, reflecting the fact Japan’s economic bubble in the 1980s is almost without precedent. In US dollar terms, Japanese stocks rose 10-fold between 1982 and 1989 and were trading at 60 times trailing earnings.
Japan was easily the world's biggest stock market at that time, accounting for 45 per cent of global market capitalisation. By 1990, notes Ben Carlson of Ritholtz Wealth Management, the Japanese property market was valued at roughly four times that of the entire United States; the grounds of the Imperial Palace were estimated to be worth more than all of Canada; and there were more than 20 golf clubs that cost more than $1 million to join. This was, suggests Carlson, one of the greatest bubbles of all time. In other words, Japan is indeed a freak case. Stocks always carry risk but they're rarely if ever as risky as they were in Japan in 1989, so it would be unwise to be too spooked by the Japanese experience. The "stocks for the long run" argument rests largely on US data showing stocks have never failed to beat inflation over a 20-year period, generating annualised returns of 9-10 per cent over the past century.
However, if Japan is atypical, so too is the US. Data from London Business School professor Elroy Dimson, co-author of the annual Global Investment Returns Yearbook, shows the US is one of only four countries in the 20th century where stocks have always beaten inflation over 20-year periods. The US was the big economic winner of the 20th century, but no one could have predicted this with any certainty in advance. Investors might have thought German stocks represented a better bet, only to see their investment wiped out by hyperinflation in the 1920s and by the second World War.
They might have fancied tsarist Russia, then one of the biggest equity markets in the world, only for the 1917 Russian Revolution to turn stock certificates "into fancy facial tissue", as former Morningstar analyst Samuel Lee once put it. Lee notes that numerous other countries, including Argentina, Greece, Chile, Romania, Czechoslovakia, Hungary, and Poland are examples of states whose stock markets disappeared at some point in the 20th century.
Extreme cases? No doubt, but long stock market droughts are much more common than one might think. Most European markets, for example, have gone nowhere over the past 17 years.
Prof Dimson’s data shows Britain once experienced a 22-year period where stocks failed to keep up with inflation. Japan, Germany and Spain have all experienced 50-year periods where stocks lagged inflation. France’s longest streak lasted 66 years. Italy’s 73-year drought only ended in 1978. Worst of all is Austria, where stocks lagged inflation over a 97-year period. None of this necessarily means the “buy and hold” mantra is a false one. The reality is that countless studies have shown that trading and market timing hurts returns. More often than not, it pays to hold on when the going gets tough.
Furthermore, if one changes one’s starting point, the data can appear very different. Carlson notes that in Japan, for example, stocks have actually generated annualised returns of 9.3 per cent since 1970, courtesy of the gargantuan returns generated in the 1970s and 1980s. Still, “the truth is that buy and hold doesn’t always work over every single period”, adds Carlson. “There almost have to be periods where buy and hold doesn’t work, otherwise everyone would do it.”
In particular, the last three decades in Japan are proof that even very long-term investors cannot afford to dismiss the importance of starting valuations.
As noted earlier, Japanese valuations were obscene in the late 1980s – roughly twice as high as US valuations at the peak of the dotcom bubble in the late 1990s. The subsequent collapse resulted in Japan’s share of the global stock market falling from 45 per cent to 8 per cent. Eight of the 10 largest companies in the world were Japanese, five of them banks; today, the 10 most valuable companies are all American.
Although Japanese stocks have been a lousy investment in recent decades, value investors have managed to make money. Between 1981 and 2010, for example, buying the highest-yielding Japanese stocks – typically cheap and unloved firms – generated annualised returns of 13.6 per cent, compared to 3.97 per cent for the Nikkei. Furthermore, investors who bought when the broader Japanese market was relatively cheap have tended to enjoy decent returns over the following 10 years, whereas 10-year returns have been awful for investors who bought when price-earnings ratios were especially elevated.
The other obvious lesson is to beware of home bias – investors’ tendency to overweight their domestic market – and to ensure one’s portfolio is diversified. Carlson notes that Japanese investors could have eased their pain by stocking up on government bonds, which returned 6.1 per cent annually between 1990 and 2015.
They would have done much better again if they had a global stock market portfolio, as opposed to Japan-centric holdings. Today, the US is the most expensive major market. Valuations are not bubbly, but they are elevated relative to history, suggesting long-term returns are likely to disappoint. Despite this, even legendary investors such as Warren Buffett and Vanguard founder John Bogle recommend investors buy the S&P 500 and forget about non-US stock markets. It's a curious stance and a dangerous one. Japan's stock market experience has been an extreme one, but it is by no means the only country where long-term returns have been disappointing. Putting all your eggs in one basket – and the most expensive basket at that – is not a recipe for long-term success, as many unfortunate Japanese investors will attest.