How low can the market go? A Japanese case study

Danny Hines

Danny Hines • 7 min read

Posted Sep 14, 2022



So stonks have underperformed lately. The S&P is down ~20% from its peak, growth stocks are much worse off, and the negativity is building. The consensus is that interest rates were too low for too long, combined with insane government spending which caused an asset bubble and a picture of a monkey to be worth $500k. The current downtrend is the market reacting to the idea that the government won't give away money for free anymore. Handing out $1 trillion in cash was a bad idea, and people who make money off of money got greedy again. Who woulda thought?

Keeping inflation under control is half of the Fed's job. Because they didn’t act when inflation started climbing last year, Jerome "Money Printer" Powell now has the impossible task of raising interest rates without causing a recession. According to NPR, 2/3 of the previous US recessions were caused by the Fed raising interest rates, which is exactly what they plan on doing over the next year.

The market:

I can go lower meme

The federal funds rate determines how expensive it is to borrow money. Ideally it should be non-zero if the equity and labor markets are doing well, because you should have something to fall back to when we inevitably enter a bear market.

During the Great Recession the U.S. was forced to cut rates to zero, and discovered that it’s pretty awesome when the entire market go up by 15% every year, so they kept them near zero. The next 10 years and 8 months was the longest expansion in U.S. history, followed by Covid which caused more 0% rates and your garbage man to start collecting NFTs. George Bush was in office the last time we had 3% interest rates, so we’re in a bit of a bubble. A sticky one at that. A big sticky bubble.

Fed Funds rate since 1965

Where’s the bottom?

Since 1946, the average bear market has seen a 35.8% drop from peak to trough when it’s accompanied by a recession, or 28% without an accompanying recession [1]. Apparently we’re not technically in a recession yet, but NBER’s calculation is based on government employees walking into grocery stores and writing down the price of milk every month - so the announcement is usually late.

A few weeks ago I asked my dad what he thought. He said he expected it to fall further, and that depending on Fed’s action it could get much worse. I told him my plan of putting money back into equites soon, because in a few years from now we’ll be at new highs. It will always be up in the long run. "Sure, that's been the case in the US. But some markets never recover. Have you ever seen a historical chart of Japan's version of the S&P, the Nikkei?”

The Nikkei

The Nikkei Stock Average is the index for the Tokyo Stock Exchange, which is a pre-weighted index of 225 of the largest publicly-traded companies in Japan. In other words, the Japanese equivalent of the S&P 500.

In the early 1980’s, both the US and Japanese economies were expanding, but the value of the US dollar grew rapidly relative to other currencies and the US was left with a massive trade gap. So in 1985, the US, UK, France, Germany and Japan signed the Plaza Accord, which aimed to even the trade gap and depreciate the value of the U.S. dollar.

US Japan trade deficit
U.S. trade deficit from 1980-86
US Yen exchange rate
U.S. / Yen exchange rate from 1980-86

It worked - maybe too well. The result was that the value of the dollar fell dramatically against the yen. In turn, Japan started spending like crazy, scooping up assets across the world including U.S. companies and real estate. Americans began to get the impression that Japan would overtake the United States as the world’s economic super power. Japanese cartoons like Transformers and Thundercats became mainstream, and Hollywood depicted a future where all Americans work for Japanese companies like in Back to the Future 2.

Japan buying spree

Then in 1989 as the party was raging, a man named Yasushi Mieno took over as president of the Bank of Japan, unplugged the sound system and told everyone to go home. He raised rates, and the party stopped. Then he raised rates even more, proverbially asking all his hungover friends to help clean up from the night before and also Venmo Josh for the beer.

The bubble burst, and the Japanese economy went pffft. The Nikkei reached 38,957 at the peak in December 1989. A year later, it was around 24,000.

Why did my dad mention the Nikkei? Because it never recovered. It continued to drop until it fell below 8,000 in 2003, and returned to that level in 2009. Over three decades later, the index still hasn’t reached its artificially-high peak, only barely breaking 30,000 last year (2021) before the current downturn:

The Nikkei 225 since 1970
Nikkei 225 since January 1970, from Wikimedia

And while the situation is very different than Japan in 1990, the growth of the S&P 500 has been wild:

S&P 500 since 1928
The S&P 500 since 1928. Sometimes you'll also see the logarithmic version which is more normalized.

The long run

The long run is tough to define - in the economics papers this guy looked at, the "long run" ranged from 3 to 10,000 years. The median "long run" was 32 years, which ironically is about how long it took for the S&P to recover after the Great Depression.

The United States has gone through 23 recessions since 1900, and it’s always gone back up. Boom and bust cycles are unavoidable and are a reflection of human nature. This recession - and it probably is a recession - will probably last 12-18 months and look like an amalgamation of the previous ones, with earnings, wages and employment to drop as inflation gets under control. Of course I don't know for sure, and anyone who tells you they do is lying.

But based on all historical evidence, in the long run the S&P will be much higher than it is today. I also believe the Nikkei will break 40,000 at some point. But despite my confidence I don’t want to forget: the world’s third largest economy experienced a bubble 5 years before I was born, and they still haven't recovered. When finance gurus say "you'll always be up in the long run”, they don’t say how long you’ll have to wait.

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