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.

Despite all those efforts and all that cash, the Japanese economy struggled along through a series of recessions in the '90s. Fiscal stimulus packages would temporarily boost demand and send the stock market higher, but when those stimuli faded the same negative underlying economic trends reasserted their dominance. The economy and market clearly underperformed most other developed-world markets such as the US and the UK.

Mark Twain once said that history doesn't repeat itself but it does rhyme. There are clearly differences between the US and Japanese experience. For example, the US government and private markets have responded more quickly to the deflationary environment and financial crisis we currently face than policymakers in Japan back in the '90s. In addition, the residential property bubble in the US wasn't nearly as inflated as that of Japan in the late '80s.

On the flip side, Japanese consumers had a huge pile of savings to fall back on; American consumers are largely in debt, and the savings rate has only recently begun to rise to historically sustainable levels.

But all that said, it seems fair to say there's a great deal in common between the current environment in the US and that of Japan in the '90s. Check out a chart of the Nikkei 225 from the late '80s to 2002.


Source: Bloomberg

This is the part investors should really care about. As you can see, the '90s began with a dramatic decline for the Nikkei. Subsequent to that, the index traded in a broad range for about 10 years. The Nikkei went nowhere.

That's not to say investors couldn't make money in '90s-era Japan or can't make money if a similar pattern emerges for the US. This is a monthly chart of the Nikkei and, as you can see, I've labeled several impressive rallies within Japan's Lost Decade, some lasting between one and two years. These moves can be extremely profitable for investors who are well positioned in the right sectors and nimble enough to take profits from time to time.

Some stocks and sectors performed well even as the Nikkei marched in place. For example, investors who purchased Toyota Motor Company (NYSE: TM) on the last trading day of 1989 and sold in the last trading day of 1999 earned more than 260 percent on their money, equivalent to 13.7 percent annualized. And investors who bought Japanese firms that build roads and bridges also saw huge gains when government coffers were opened periodically throughout the '90s.

More sophisticated investors in Japan were also able to bring their vast pool of savings to bear overseas. As all investors are aware, the US and most European bourses performed phenomenally well even as the Nikkei languished.

As I've noted here as well as in Personal Finance, I do expect a recovery for the stock market and economy in coming months. This rally will likely be dramatic--and well-placed investors will see impressive gains.

But given the Japanese experience as a roadmap, I'm not looking for the start of a new bull market in the US averages for years to come. I suspect we're in for a prolonged period of subpar growth, at least compared to what American investors have come to expect over the past 20 years. It's clear to me that, like it or hate it, the state is going to take on a bigger role in the economy. This opens up some investment opportunities, though it also likely means far more restrained growth.

Investors with a longer-term growth perspective should focus their attention overseas to Asia or to sectors such as energy and commodities that stand to benefit from Asia's growth. If you're interested in that angle, my friend and colleague Yiannis Mostrous has written several recent articles in PF and has an outstanding Asia-focused newsletter, Silk Road Investor. Yiannis is my go-to source for the latest trends in Asia.

For those looking to play the intermediate term trends in the US, my top four sectors right now are: health care, technology, energy and consumer staples. See the last few issues of PF for our top plays.

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