Any discussion on long-term stock returns inevitably turns to the unfortunate experience of Japanese investors who saw the Nikkei 225 tumble from the 38,915 it closed in 1989 to its current level of just above 7,500 nearly twenty years later. Stated in these stark terms without any context, the Japanese example appears to question the validity of buying-and-holding equities for the long run but appearances are deceptive.
Japanese stocks increased 100-fold from 1955 to 1990. Between 1986 and 1989, the Nikkei 225, a price-weighted average of stocks trading on the Tokyo Stock Exchange, tripled in value and stocks traded at unheard of valuations: 60 times earnings, almost 5 times book value and more than 200 times dividends. Nippon Telephone and Telegraph (NTT) traded at a P/E of over 300. The collapse from these dizzying valuation levels was shift and brutal — the Nikkei lost 38.7%, 3.6% and 26.3% over the subsequent years for a total loss of over 56% in three short years.
And as is common in bubbles, the “this time is different” arguments were common. Jeremy Siegel, relates the following anecdote in Stocks for the Long Run:
During his travels to Japan in 1987, Leo Melamed, president of the Chicago Mercantile Exchange, asked his hosts how such remarkably high valuations could be warranted. “You don’t understand,” they responded. “We’ve moved to an entirely new way of valuing stocks here in Japan.” And that is when Melamed knew Japanese stocks were doomed, for it is when investors cast aside the lessons of history that those lessons come back to haunt them.
The lesson to be drawn from Japanese stocks then is that valuations matter a great deal. Stocks cannot be expected to provide satisfactory returns if investors pay too high a price. It was true of Japanese stocks in the late 1980s, US stocks in general and tech stocks in particular in the late 1990s and will hold true in the future.
