The End Game

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The US stock market has rallied sharply from extremely oversold levels. There's no catalyst I can single out to explain this move; however, I suspect it's a combination of some slightly more positive US economic data, coupled with stabilization among the financials and simple short-covering.

There are also some real signs of reaccelerating growth in China, the most obvious a recovery in the price of crude oil back above $50 despite relatively bearish US oil inventory reports.

As regular readers know, I'm not yet seeing any evidence of a durable economic recovery in the US. None of the indicators within the Conference Board's Index of Leading Economic indicators are showing any real bullish trends, with the possible exception of money supply growth and interest rate spreads. As I explained in the March 20, 2009 issue, these factors won't form the firm foundation for a recovery.

This rally could continue in fits and starts for at least another month. Ultimately, however, I'm looking for the market to retest recent lows sometime late this spring or over the summer. A more likely window for a real rally would be in the back half of the year; if the US economy does see a recovery in 2010, the market should begin rallying roughly five months ahead of the trough.

But these are just intermediate-term projections based on prior cycles. The larger question is what investors can expect to see in the coming years for the stock market. Obviously, any projection of this nature is more educated guess than certainty, but I suspect investors who are looking for a return to a 1990s-style bull market in the US will be sorely disappointed. The more likely outcome would be a market such as we witnessed from 1968 to 1982 in the US or something akin to Japan in the '90s.

Let's consider the case of Japan. The nation saw general prosperity for decades after World War II. Japanese electronics and automobile brands became household words for most of the world and the nation became the second-largest economy in the world after the US. Many investors will remember in the late '80s, when it became fashionable to write about Japanese-style management techniques and corporate practices; the nation's economic miracle was the envy of the world.

But the Japanese economy wasn't without its own set of problems. The Japanese real estate market became perhaps the most dramatic financial bubble since the Tulip bulb craze in 17th century Holland. At the height of the bubble, the land under the Imperial Palace in Tokyo would have been worth more than the entire state of California. The average Japanese home cost close to 200 times the average Japanese salary. Suffice to say the real estate boom in Japan in the '80s puts the US residential real estate bubble of 2000-05 to shame.

The stock market was similarly in bubble territory. Amid all the positive sentiment about Japan's economic miracle, companies soared to valuations that would have been unheard of in the US or any other country. Of course, there were plenty of pundits who sought to justify these valuations as reasonable.

But both bubbles did burst. Check out my chart of the year-over-year change in Japanese land prices below.

Source: Bloomberg

As you can see, Japanese land prices routinely rose by 20 to 30 percent annually at the height of the '80s-era bubble. By 1992, however, property values were shrinking, and falling prices ensued for more than a decade until the 2003-05 period. In other words, the real estate market experienced severe deflation throughout the '90s.

The Japanese government didn't just sit by and watch all this happen. In the early '90s, the central bank began cutting interest rates to stimulate growth. Throughout the '90s a series of Japanese governments launched fiscal spending drives focused on public works projects--the classic Keynesian economic response. Sound familiar?

And despite politicians' attempts to separate the two, there's really no distinction between Main Street and Wall Street. The pricking of Japan's stock and property bubbles and the economic malaise that ensued had dire effects on Japan's banks. Many of the loans made by these banks in the '80s were collateralized by rapidly depreciating real estate. In other words, Japanese banks were stuck sitting on piles of bad debts.

Even worse, rather than allowing big, well-known companies to go bust, Japanese banks continued lending to these "zombie" firms for years, postponing the inevitable day of reckoning.

The Japanese didn't government sit around while all this happened in the financial system. There were several attempts to recapitalize the banks through direct injections of capital and various forms of depositor guarantees. The government also actively encouraged mergers between big banks. This, too, should sound familiar; it's a decent summary of what's going on in the US right now.

The end result of this succession of bailouts, government public works spending and easy monetary policy is pictured below.

Source: Bloomberg

This chart shows the Japan's total debt-to-GDP ratio going back to 1970. As you can see, the ratio exploded, nearly tripling from around 60 percent in the early '90s to about 180 percent in the early part of the current decade.