The biggest asset bubble ever: 1980s Japan - Case Study

I do a lot of analysis around long-term returns in the stock market. Countries vs countries. Funds vs funds. Sectors vs sectors. While past returns are never indicative of future performance, studying what has happened before provides a good framework for what goes next. 

Last year I published some research centred around three influential facts with regard to US the stock market:

1. Most active investors fail to beat the market
2. The S&P 500 has an inflation-adjusted historical return of 8.5% on average
3. The market is extremely volatile

This volatile but upward trajectory applies to the US stock market. However, it does not hold everywhere. In fact, this takes us to what is, by many metrics, the biggest asset bubble in human history: the Japanese stock market of the 1980s. 

What happened to the Japanese stock market?

Outrageous. That is the first word that comes to mind when describing the gains printed by the Japanese stock market in the 1980s. 

The Nikkei 225 (a price weighted index made up of 225 publicly traded stocks on the Tokyo Stock Exchange) opened the 1980s trading at a level of 6,560. Ten years later, it closed the decade trading close to 39,000. Today, 33 years on from that peak, the index still trades 23% below that level, at around 30,000 at time of writing. 

To be underwater on one’s investment 33 years on is a staggering fact, and significantly so at that, down 23%. But such was the pace and enormity of the Japanese expansion in the 80s that, three decades on from the bubble popping, poorly-timed investors are still waiting to break even. 

There are some statistics which illustrate quite how dizzying things got back then. First, examine the annual returns:

That is close to a 500% return. That is definitely stout, but not exactly jaw-dropping. So let’s dig into it some more. Firstly, the growth peaked in the 80s, but the 50s, 60s and 70s were also a boon for investors. 

In fact, the Nikkei opened the 50s trading at 101.68. By the peak four decades later, it was 38,921, meaning a $100 investment in 1950 would have grown to $38,277 by 1990 (note I am using dollars throughout this article for simplicity, but of course the Nikkei is yen-based, so if you are an American investor, there will be FX effects here too). 

But to paint the size of the bubble in context, one needs to compare internationally, or benchmark to economic indicators. My favourite is another simple one: by the end of the 80s, Japanese stocks represented nearly 45% of the global stock market. For comparison, the US was second at 33%, and the UK in third, below 10%. 

The top four companies in the world by market cap were Japanese, with thirteen Japanese companies in the top twenty. 

What about comparing to earnings, the classic valuation technique? The P/E ratio of the Nikkei rose above 60X at its peak. Globally, the average at the time was 15X, meaning the Nikkei was four times higher. 

Looking at the CAPE ratio, which compares a stock’s price to its cyclically adjusted earnings over ten years, Japanese stocks nearly breached 100X. Comparing this to perhaps the most notorious bubble in recent times, the dot com bubble, is not even close – US stocks didn’t breach 50X during the mayhem of 1999/2000. 

Japanese real estate market

Clearly, stock valuations were preposterous, but the bubble was not limited to equities. Japanese real estate increased by over 50X between 1955 and 1986. Over the same time period, consumer prices only doubled. The chart of residential real estate below shows that even today, house prices are a far cry from the peak, despite most other Western nations seeing prices go vertical in recent years.  

Looking at Tokyo specifically, the average price of a home was 15X the average income. For reference, I published a report on the UK market a few weeks ago, as this ratio has just breached 9, an all-time high and in the midst of a housing crisis. The Japanese numbers are truly hard to believe when put in context.

The collapse of the Japanese bubble

The bubble, like bubbles tend to do, burst. Somewhat poetically, the stock market peak came on the final day of trading in the 1980s, when the Nikkei closed at 38,915. As I write this in 2023, it still has not come close to those levels again. 

The market experienced a 39% decline in 1990. 1991 was not as bad, closing the year down less than 4%. But then 1992 brought another 26% loss. The Nikkei had lost nearly 60% in three years. 

However, while the Nikkei 225 is still trading below the levels from 30 years ago, it is important to note that this is without dividends. This is therefore not a totally realistic picture – with dividends included, the index is currently less than 5% off the level it was at 30 years ago, at the peak of the bubble. Obviously, this is still a horrendous return, but it is not quite as bad and the caveat is an important one. 

Overall, the fact doesn’t change the statement that, in terms of total dollar value, the Japanese bubble is likely the greatest in human history. 

Will the US stock market crash?

The most interesting question to come out of this Japanese analysis is the following: does this highlight a massive risk to long-term investing? Or is it foolish to assume that the S&P 500 is a safe long-term investment when considering what happened in Japan?

To this, I would say there are two vital points to mention. The first is the concept of dollar-cost averaging. In the real world, it is rare for anybody to enter the market with a large sum of money and then never invest again. More likely, we see consistent investment over the course of many years as individuals work, earn money and grow older, with their financial and life circumstances changing as time goes on. 

This changes the entire scope of the analysis. To illustrate how, let me pull up a model I built for a recent piece on dollar-cost averaging in the US market. 

The below chart is a visualisation of the current value of monthly investments of $100 in the US stock market, starting right from the top of the bull market on December 2021. In other words, the investor enters the market *right* at the bull market peak. 

Despite entering the market at the worst possible time, by April 2023 (when the chart was created), they were in profit. This is despite investing through the worst bear market of the past twenty years. Obviously, this is specific to the US and the market has bounced back up since, but it is a nice way to demonstrate that by consistently investing over a period of time, the returns will never be as dramatic as if one had invested right at the top. Had the investor just put all their cash into the market at the very peak and never invested again, they would still be down 14% (first bar in chart – a $100 investment is currently worth $86). 

In Japan, it is the same. While an investment at the peak of the market is currently down 23%, if one had invested the same amount annually, starting the day of the stock market peak in 1989 and continuing ever since, they would be up 90%. And again, that is without considering dividends.

Hence, while the returns can be dramatised from the peak, the jaw-dropping 23% loss over 30 years is not a very realistic scenario when it comes to a practical investor. Having said that, a 90% return in 30 years is still abhorrent, and you quite literally could have done anything else with your spare cash and made a better return. 

The second point to consider when assessing the likelihood of this happening in the US is the fact that valuations in the S&P 500 are not as out of whack when compared to other markets around the world. I went into the valuations earlier in the piece around P/E ratios, CAPE ratios and what portion of the market cap of global equities was in Japan. These were all astonishing numbers and nothing compares to them today, in the US or elsewhere. 

US stocks have been more expensive than other countries for a while now, as the below chart demonstrates, but the discrepancy is not even in the same league as what we saw in Japan, when the P/E ratio of the Nikkei was four times the global average. 

Final thoughts

The Japanese stock bubble of the 80s is a terrifying case study. While something similar in the US would rock the financial world, there are plenty of factors that explain what happened in Japan and are not necessarily indicative of the US state of affairs. 

That being said, it is a cautionary tale for investors around the concept of risk, especially with regard to time horizons. In essence, stocks pay a return to compensate investors for bearing short-term volatility. This is why time horizon and diversification is key when it comes to buying in the stock market. It is also why purchasing over a prolonged period and in a consistent manner spreads out the risk as opposed to one lump entry. 

There is nothing to suggest the Japanese situation is imminent for US stocks. But nobody knows what will happen in the future, least of all me. An assumption of an 8% return, or 10% with dividends (which should be included in all financial projections, and needs to be considered when assessing the Japanese situation) is a standard one for long-term US stocks, but this is far from guaranteed. 

But to finish off, opportunity cost can be the greatest of all. Sitting on the sidelines while investors enjoy lucrative gains, especially in recent years as money printers have been warm and inflation has surged in conjunction with asset prices, has been a bitter pill to swallow. Paranoia is a dangerous game, and I have picked quite literally the worst asset bubble in history for this piece. 

A long-term time horizon and prudent portfolio allocation remains king, and this horror story from Japan certainly won’t keep me out of the US stock market. To me, that would be the biggest gamble of all, and one that even the numbers behind this horror story struggle to justify.