What Collapse of Japanese Stock Market May Mean for U.S. Investors

The collapse of the Japanese stock market has raised two questions in the minds of American investors. The bolder ones want to know whether it is time to start buying Japanese stocks now that their conventional valuation measures, such as price-earnings ratios, are nearer their levels in Western markets. The more cautious wonder whether to sell their U.S. stocks on the fear that the collapse of Japanese stock prices will spread and pull down the U.S. market.

The changes in Japanese stock prices have indeed been spectacular. For several years through 1989, they soared beyond any levels that experience with Western markets would have predicted.

Since then, they have been falling for more than two years, though with a few sharp upswings along the way. As of the end of April, the broad market average was at less than half its peak level, and many individual stocks had fared much worse. Financial firms, such as Nomura Securities Co. and Nippon Telephone & Telegraph Corp., have fallen to just 20% of their peak prices. These companies are giants of the Japanese economy, not speculative start-up companies that often fail and crash. So it is no wonder that some bargain hunters believe that it is time to buy.

Stock prices are moved, in part, by fundamental developments in the economy, such as interest rates, and in individual firms, such as profits prospects. But in part they also have their own dynamics that can lead to prices overshooting both above and below fundamental values. Both fundamentals and internal dynamics have been part of the roller-coaster ride of Japan’s stock market.

Fundamentals changed in a big way for Japanese stocks in the last few years. Part of the success of Japanese manufacturing and the run-up in the prices of Japanese land and stocks had come from the extraordinarily low interest rates maintained throughout most of the 1980s by the Bank of Japan. Starting in late 1989, a new central bank chairman started bringing Japanese rates more nearly in line with those in other industrial nations, in large part to head off still further increases in asset prices.

The new interest rates were hardly Draconian, but they were a big change from the past and contributed directly to the steep decline in stock prices by putting a bigger discount on future earnings of firms. In addition, as Japanese firms began to confront borrowing costs and price-earnings multiples much more like those in the West, they lost the big competitive edge that the low cost of capital had provided. For this season, and because of growing Western political resistance to Japanese trade practices, analysts have lowered projected sales and earnings for Japanese firms.

Where should that leave the bold investor who is tempted to start buying? Wall Street has maxims for all occasions, and for this one it is, “Don’t try to catch a falling knife.” Although prices have fallen a lot, the fundamentals underpinning them have worsened too. What is more, Japanese accounting and institutional practices are hard to penetrate, making it especially difficult to relate prices to fundamentals and to decide when they are reasonably in line. And finally, the overshooting that characterizes major market swings could still lie ahead, meaning prices could fall below the levels justified by fundamentals before finally turning up.

So, even more than when considering investing in U.S. stocks, the individual should probably rely on investing through a mutual fund that targets foreign markets. These funds employ experienced analysts and portfolio managers who are constantly making judgments about Japanese stocks. Seek out the best of these funds, and leave it to their managers to decide when to step in.

What about the cautious investor who is tempted to sell U.S. stocks out of fear that the Japanese price decline will spread to our markets? U.S. stocks rose a lot during most of the 1980s, but not nearly as much as the Japanese market. If the connection was not strong on the upside, why believe that it will be there on the downside? Wall Street’s maxim for this case is, “If you did not attend the wedding, you don’t have to attend the funeral.”

True, studies have generally found positive correlations between the movements of markets in different countries. If all you know is that London prices were up in the morning, there is a presumption that New York will be up later in the day.

But it is useful to distinguish between two possible causes of such positive correlations between two markets. Both markets can react in the same direction to a common economic surprise--say the invasion of Kuwait that threatened world oil supplies. This source of correlation is doubtless important. Or conceivably, one market could react to price movements in the other even though no common fundamentals have changed, but rather because of a market’s own dynamics. This correlation seems much more dubious. Such pure price contagion without a common fundamental cause is especially unlikely when one market’s investors are a relatively small factor in the other market.

And despite frequent assertions to the contrary, we have not become dependent on Japanese investment dollars. In the peak year, 1987, Japanese investors made net purchases of $11 billion of U.S. stocks. In the years since then, their net purchases averaged about $1 billion a year. This activity is totally dwarfed by inflows to U.S. stock mutual funds, which came to $20 billion in the first quarter of this year alone.

The U.S.-Japan investment link is not a major factor in American stock markets. And changes in their fundamentals have not been mirrored here. If we get a major decline in stock prices, it will be home-grown, not made in Japan.