The slipping economic expectations, depressed bond yields and deflation talk in the United States all have an eerie ring to them: Japan, early 1990s.
That’s a disturbing concept, because Japan’s economic turmoil – which, like the current U.S. situation, was brought on by a banking crisis – was followed by almost 20 years of a sideways-to-downward drift in equities. And while some critics are quick to find differences in Japan’s situation versus today’s U.S. predicament, there are enough similarities to question whether the U.S. stock market might be headed down the same dead-end road.
But rather than focus on the similarities and differences between the two economic case studies, David Bianco of Merrill Lynch decided to look at the structure of the two equity markets themselves. Do they look enough alike that one should expect the U.S. market to react the way Japan’s has to a weak growth and interest rate outlook?
Apple Pies To Oranges
Mr. Bianco said that far from being comparable, “the differences between the S&P 500 and the [Japanese] Topix [index] are striking.”
Most disparate are the all-important price-to-earnings valuations of the S&P 500 of the present era versus the Topix of the 1990s.
“Japan typically traded at a 30-40 P/E for most of the 1990s, and after a decade of deflation, it still trades at a 15 P/E,” he wrote in a research report. “This compares to the S&P 500 now trading at 12.8 times current EPS [earnings per share].”
He added that the spread between the earnings yield (annual earnings per share as a percentage of the stock price) and the 10-year government bond yield in the U.S. is more than six percentage points, implying that equities are priced at a steep risk discount to Treasuries. In contrast, Japan’s earnings-yield-to-bond-yield spread was actually negative in the early 1990s, and now is just a bit over four percentage points.
“Is the S&P 500 1.5 times more risky than Japan?” he asked rhetorically.
But watch the financials
Mr. Bianco also noted that the Japanese stock market’s exposure to the financial sector has been much higher than the U.S. market, thus exposing it to more of the negative impact of a long-term low-rate environment. The Topix’s weighting in the financial sector was about 30 per cent in 1992 and was still 27 per cent two years into the crisis in 1994. For the S&P 500, financials were less than 18 per cent of the index at the start of 2008 and are just 16 per cent today.
However, he cautioned, financials could still be at risk of Japan-like effects if the feared “Japanization” of U.S. interest rates persists.
“A further decline in long-term interest rates raises EPS risk for most banks,” he said.
