Bubble Economics: Does Japan of 1990 Sound Familiar?

More and more, the U.S. stock market is looking like another famous bubble: Japan of the late 1980s.

Back then the Nikkei Average was the bullet train of global equity markets. It seemed unstoppable, at least until the Bank of Japan started raising interest rates. Then the market jumped the rails and remains -- more than ten years later -- a crumpled wreck.

If that cause-and-effect relationship spooks you, particularly with the Federal Reserve likely to raise rates next week, you won't enjoy contemplating other doppelgangers from Japan's experience. However, significant differences between the U.S. of 2000 and the Japan of 1990 suggest America will likely forestall an out-and-out collapse, although rough times are almost certainly ahead. By being aware of the big-picture economics and remaining disciplined, you can avoid becoming the Casey Jones of your own portfolio.

The similarities between the situations merit some attention, if only for their starkness. Hard-to-swallow defenses of distended tech valuations are reminiscent of the arguments trotted out for buying Japanese shares at the top of that market. American "new paradigm" thinking seems frighteningly similar to Japanese management "triumphalism." Rising land prices, falling unemployment and rambunctious consumer spending all describe America today as well as they described Japan a decade ago.

The most vexing concern for professionals and individuals alike is that the U.S. economy, red-hot, like Japan's in the late 80s, shows no sign of slowing. It grew a fiery 5.4% in the first quarter even though central bankers have been raising borrowing costs since June 1999. That is suggestive of Japan in the 1980s, when the economy kept roaring along even as borrowing costs were ratcheted higher.

Between May 1989 and August 1990, the BOJ raised the official discount rate, the most important rate in Japan at the time, on five occasions for a total 3.5 percentage points. Japanese central bankers continued raising rates even after the Nikkei collapsed from its peak of near 40,000 in late December 1989 to below 30,000 by early 1990. Ominously, it trades at less than half its high 10 years later.

Bank of Japan vs. Nikkei Average May 1989 to present

Source: Baseline and Bank of Japan

This is where the similarities end.

While the Fed will likely follow a similar pattern of lifting rates even after Tuesday, which is expected to yield a 50 basis-point hike, it has taken a gradualist approach. The Fed has raised rates five times over the last ten months, each time by 25 basis points. That's nowhere near as drastic as the BOJ's clumsy tightening, which included a 100 basis-point hike even after the stock market had been just about halved.

"If you believe Japan was aggressive, then the Fed's approach is right," says Ron Bevacqua, an economist at Commerzbank in Tokyo who thinks Greenspan & Co. have a reasonable shot at engineering a soft landing. "If you believe the Fed is behind the curve, this sort of nickle-and-diming only puts them further behind."

Another key difference is that American companies and consumers have far more borrowing alternatives than the Japanese, who were stuck with just banks and nonbank lenders. When those institutions stopped lending, the Japanese stopped buying, bringing the economy to a halt. U.S. companies can tap the deepest capital markets in the world and American consumers have an array of financing options that would make the Japanese drool.

"You can borrow against your 401(k). You don't have to buy a car, you can lease one," says Alexander Muromcew, who manages the Japan portion of the (LSIEX Quote)Loomis Sayles International Equity fund. "You can be quite creative if you are risk-tolerant as to how you finance your lifestyle."

Perhaps the most significant difference is that much of America's bubble is confined to the broad technology group, particularly those companies seen as Internet plays. Earnings are so far away for many of these companies, you'd be hard-pressed to see them without a telescope. But that's not the same for blue-chips, which have just come out of a spectacular earnings season. Nearly 40% of S&P 500 companies have reported positive earnings surprises in the first quarter, according to data provider First Call/Thomson Financial.

Massaki Higashida, a deputy manager at Japanese brokerage giant Nomura Securities, says the quality of the companies and their earnings is the key difference between the U.S. and Japanese experience. "In Japan, everything was in a bubble," says Higashida, who remembers the heady days his company helped to cause. "In the U.S., Nasdaq stocks are in a bubble, but the blue-chip stocks aren't. The blue-chips have earnings and strong businesses."

The Japanese learned that lesson. After an initial crushing fall, Japanese investors sought out blue-chips such as world-leading companies like Sony (SNE Quote) that benefited from a strong global position. That investing discipline helped push the Chicago Board Options Exchange's 40-stock Japan Export Index near all-time highs even as the Nikkei plumbed post-bubble depths. (The JEX index is no longer calculated by the exchange.)

Remember those savvy Japanese who got Sony in 1990 only to see it rise more than four times over. If times get tough, stick with what works.