Will US stocks follow the Japanese lost decade pattern?

Appropriately enough it was the Japanese broker Nomura that raised the possibility of US stocks following the Japanese pattern of the lost decade of the 1990s at a conference held in the Dubai International Financial Centre this morning.

It struck an instant chord. The graph above shows the 1990 crash in Tokyo and superimposes the post 2007 Wall Street collapse. The rally from the lows of March last year is clearly seen, and the question is what comes next?

Rally too strong

After a V-shaped bounce in stocks and a U-shaped economic recovery the probability must surely be a correction, perhaps falling close to or surpassing previous lows.

Yet we know that the private sector credit boom that fueled the US economy to higher rates of growth has gone, and with people more interested in paying off debts and saving now the prospects must be for a lower rate of economic growth than heretofore.

The US housing market is still clearly in decline as evidenced by the 17 per cent fall in December existing home sales, the worst monthly fall in 40 years. Mortgage foreclosures in the millions this year will not support prices, so why buy a house if prices are still falling?

Is this post credit bubble economic scenario not very similar to the bursting of the real estate and equity bubble seen in Japan in 1990? If so then the outlook for equities might reasonably be expected to be very similar, namely over-optimism about recovery potential followed by a realization that the boom years are not coming back.

A lower level of range-bound trading activity – effectively going nowhere – might then be a realistic scenario. There might well be trading opportunities within that range. But then again far better investment opportunities would likely be on offer in completely different asset classes with a far more investor-friendly valuation outlook.

Tough choice

For optimistic US pensioners this presents a dilemma: stick with what you know and become poor, or at least poorer than you might be in a different asset class, or become more adventurous.

If nothing else this graph suggests that investors will become increasingly disillusioned with US equities and look elsewhere for their investments. In Japan investors bought more and more low yielding government bonds in the 1990s, not that they proved a particularly good investment either.

That probably means US investors will become more orientated towards foreign assets and commodities as their own stock market underperforms. But for those who thought the 2000s a lost decade for US equities, the next decade could be even worse.

Of course, we would be talking about US equities adjusted for inflation. It is hard to imagine a Japanese style deflation being tolerated and that would distort the comparison in real terms.