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Posted 9/2/2002
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Why Japan-style malaise could happen here
This is no ordinary bear market. Downright scary similarities exist between Japan's post-bubble struggles and the current U.S. downturn. Here's why the next couple months are critical.
By Bill Fleckenstein
Some people pick at consumer-spending statistics to "prove" the economy's got a quickening pulse. That would include a chunk of the U.S. economists. Others track the reality of its faltering blips from the trenches of retailers like Best Buy (BBY, news, msgs) and RadioShack (RSH, news, msgs). (Prognostications and profits might sweeten simultaneously if economists started renting desk space in the store aisles.) But the broadest measure of malaise comes via the crow's nest of historical example, from which analyst Jim Stack notes widespread it-can't-happen-hearing loss.
Given that this column marks the end of summer, I thought it might be worthwhile to do a quick rundown on the state of the market, and where we are now. Regular readers know that I have viewed with skepticism the notion that a new bull market began in July (or last September, for that matter), and that I have anticipated economic deceleration to occur as the year wore on. The latter is exactly what has happened, but what has surprised me is the quickening pace of the deterioration.
A couple of weeks ago, I mentioned that Best Buy's disappointing news was a negative harbinger for technology. Subsequently, we heard similar reports from RadioShack and Tech Data (TECD, news, msgs). While not a household name, the latter is one of the biggest resellers and distributors of tech products in the country. Away from the consumer-electronics sector, even more stunning news has come from Wal-Mart Stores (WMT, news, msgs), Home Depot (HD, news, msgs), Federated Department Stores (FD, news, msgs) and Office Depot (ODP, news, msgs), which have all talked about back-to-school/fall retail sales being worse than expected.
I think that while this is a surprise to some, it underscores what I have been saying for the last year -- notably, that Sept. 11 was not the end of the bear market, and not the start of a new economic recovery. I believe that the Fed will soon come to be discredited for its incorrect rosy predictions concerning the second half of this year (much as it was last year, though it got off the hook with that prognostication because of Sept. 11). Hopefully, readers took advantage of this rally to lighten up. And if the rally manages another little spurt into September, people should use that opportunity to lighten up, as well.
Fed, meet the near-dead
Now I'd like to turn to a very important subject that has been discussed in these pages -- the parallels to past bubbles, both here and in Japan. Last Wednesday, The Wall Street Journal explored this issue in its article "One reason stocks in Japan stay low: zombie companies." (Actually, its subtitle contains the most important theme: "Near-dead firms help fuel rash of price manipulation that turns off investors.") The Journal story highlights what is similar about America's bubble and what is different. What's similar is that during Japan's mania, it was an open secret that the market was manipulated. People didn't seem to mind, and in fact, stock manipulation still runs rampant there.
What's different is that part of the reason Japan has been unable to come off the mat, aside from the aftermath of its mania, is that the Japanese banks have kept businesses alive that should have gone bust. These are often referred to as the zombie companies: "alive, but nearly moribund." One thing we tend to do here in America is to let capitalism work. The dead wood does get swept away. However, the Fed is trying to use all its power to thwart the bust that follows the boom -- and this is exactly what's wrong with its present policies. Capitalism is all about creative destruction, and booms and busts are part of the landscape. Regrettably, our Fed thinks it's so omnipotent that it can stem the tide.
Not so long ago, Japan was deemed so all-powerful that people believed it, too, could ward off any problems. Further, it had one big advantage going for it that we do not: Japan was a nation of savers and a net creditor, while we are a nation of spenders and a net debtor. That said, I was short Tokyo back in the late 1980s and early 1990s, and I have followed that market fairly closely since then. In any case, I have not seen any good articles on that subject, which makes a recent analysis by Jim Stack of InvesTech Research so welcome. His piece is an absolutely spectacular recap of what people were saying about Japan back then. Jim has been kind enough to allow me to share excerpts with MSN readers, so buckle up and prepare to see how opinions have changed.
Deceive la difference
In his first topic, "Lessons from Japan: Just how trivial are they?," he writes: "It's not hard to find important differences with Japan's past bubble, and their deflationary debacle of the 1990s. After all: 1. Most of the U.S. economic damage has been confined to the financial markets. 2. U.S. employment remains high by historical comparisons with past recessions. 3. While business investment has fallen, consumer spending remains very resilient. 4. And the U.S. has one of the soundest banking systems in the world.
"At least, that's the public's assessment 28 months into the unwinding of the U.S. stock market bubble. In addition, there's no sign of the dreaded 'deflation' that marred Japan's repeated attempts at recovery over the past decade. With that said, one might be surprised or shocked to learn the following assessment of Japan's bubble at 30 months after the Nikkei Index had peaked, from a July 11, 1992, story in The Economist called 'How Japan will survive its fall.' (It's subtitled 'The economic slowdown in Japan should not be confused with a Western-style recession. Which is why Japan will come bouncing back.')
"The Economist says, 'Is Japan heading into a humdinger of a recession? The answer is no. . . . Most of the victims of the economic slowdown are so far confined to the financial and property sectors. . . . High employment is helping to support consumer confidence. Much is made of the fact that business investment . . . is falling. But consumer spending, which is almost three times as big, grew by 3.3% in the year to the first quarter. . . . The main reason that Japan . . . should be able to dodge a deep recession is that it starts off with the soundest fiscal and monetary policies of any industrial economy. This gives the government more ammunition with which to fend off a recession.' And thats from the widely respected The Economist magazine.
Slipping toward deflation -- fast
"Yes, there are important differences between the U.S. bubble of the late 1990s and Japan's bubble of the late 1980s. And there is an even greater difference in how aggressively the central bank tackled the problem. As we've pointed out in previous issues, our Federal Reserve has undertaken more easing in less than half the time as the Central Bank of Japan a decade ago. Japan's central bank cut their Discount Rate from 6% to 1.75% within 45 months after the Nikkei peaked. Alan Greenspan's Fed cut the U.S. Discount Rate from 6% to 1.25% less than 21 months after the March 2000 peak. Yet even critics of Japan's demise would be dumbfounded to learn that consumer price 'deflation' wasn't even a part of their economic debate until more than 4.5 years into the unwinding. It wasn't until mid-1994 that Japan's CPI (consumer price index) first dipped into negative territory. And it required another five years for deflation to really take hold.
"Now -- for that unique perspective again -- compare the U.S. CPI today versus that of Japan in the early 1990s. So far, we seem to be slipping toward that deflationary scenario . . . only at a faster pace. And of course, from our previous issue, the parallel paths between our S&P 500 Index ($INX) and the post-bubble Nikkei carries a worrisome, if not ominous, message. All these comparisons are not just shocking. They're downright scary! And the realization that economists' optimistic assessments were almost identical at this stage of the unwinding only adds to the anxiety. It's not that we think the U.S. economy is doomed to traverse the same decade-long series of recessions that hit Japan after their bubble burst. But unlike many analysts out there, we won't dismiss the parallels as trivial nonsense."
So, people should not find the mantra, We're different from Japan, very comforting. Yes, we're different, but many things are similar, and serious economic damage can happen here. That is the lesson from Japan's bubble, and that's also the lesson from our bubble in the 1930s. Anybody who thinks the Fed can engineer a rescue might want to consider the following quotes, also from Jim Stack's article, which chronicle just how clueless many Fed heads have been, and remain.
Confidence wanes as Fed tongues wag
"We might have greater confidence in Alan Greenspan's economic reassurances if three of his FOMC members weren't vehemently denying the U.S. was in a recession . . . a month after it had already begun (the date being March 2001, as established by the National Bureau of Economic Research). The headlines tell the tale: 'Fed's Parry says U.S. isn't in recession' -- Robert Parry, President, Federal Reserve Bank of San Francisco, Bloomberg News, April 5, 2001. 'U.S. not in recession, Fed must be vigilant -- Moskow' -- Michael Moskow, President, Federal Reserve Bank of Chicago, Reuters, April 4, 2001. 'Fed's McTeer says U.S. economy not in recession' -- Robert McTeer, President, Federal Reserve Bank of Dallas, Reuters, April 4, 2001.
"Likewise, we might have higher hopes for The Conference Board's extreme confidence; Reuters Business Report, on Aug. 14, ran the following: 'Double-dip recession seen near impossible': 'There is almost no chance of a double-dip recession in the United States, and growth in the second half of 2002 will clearly point to recovery, according to research by The Conference Board.' Just one month prior to the start of the 2001 recession, its chief economist said on Feb. 22, 'The overall signal remains one of moderation in the pace of economic activity, with no recession looming on the horizon.' And, two months after the 1990 recession had begun, its chief economist uttered this denial to CNBC on Sept. 25: 'No, we're not in a recession . . . we're not going into recession.'
"If hot air could float the economy, we'd likely have the rip-roaringest recovery in decades. But one has to question whether all this cheerleading has merely lulled our Federal Reserve into a false sense of security. After all, Consumer Confidence tumbled 9.2 points in July -- a decline seen less than 5% of the time -- primarily with the economy still in recession. In addition, the ISM Survey of Purchasing Managers just experienced its second-biggest drop in 18 years, and its 12th-biggest drop in 42 years (all but two with the economy in recession).
"And with short-term interest rates at 40-year lows, after 11 discount rate cuts, the Federal Reserve has fewer tricks left up its sleeve. What strikes us as most peculiar is how everyone seems anxious to dismiss the recent lows on Wall Street as an overreaction to accounting malfeasance. Only the diehard bears consider it a warning flag for the U.S. economy. Personally, our emotions are mixed. But it stretches the imagination to blame new market lows on accounting shenanigans at a couple dozen firms. There are deeper forces at work in this loss of confidence. They're the forces that come from popping a bubble and wiping out $7 trillion in stock market wealth. Add to that, the pressure on corporations to recoup one of the steepest earnings declines in history, and the stress on retirees who must renew their maturing 7% CDs at rates of 2% to 4%. Mix it all together, and we have a risk not seen domestically since the 1930s.
From sea to shining complacency
"This is not a normal cyclical bear market. It has lasted 28 months, making it the longest and largest bear market since the 1930s. And for the first time since the creation of the Fed in 1913, a recessionary bear market is hitting new lows six months after the recession apparently ended. The next month or two are a very critical time . . . perhaps the most critical in 60 years. If confidence doesn't stabilize and turn higher . . . and if stock prices don't hold above their July lows . . . then the economic outlook will take a significant turn for the worse. And all the jawboning, reassurances, and hot air won't prevent the economy from dropping back into recession."
I agree, and I hope readers find much food for thought in his commentary. In all the news stories about how the stock market and the economy have not been behaving as people have been led to believe, what's been missing is the kind of probe beneath surface events that Jim has so ably undertaken. It's very important for people to understand the history behind the headlines, because that will enable them to best position themselves for the trouble that lies ahead. Thanks again to Jim Stack for his analysis, and thanks to readers for bearing with me through somewhat of a long column.
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