Lacking clairvoyance, traders often look to history for clues about the market's future. Lately, skeptics have been murmuring about 1998, 1994 and/or 1987, as discussed
here, while optimists much prefer the 1991 scenario.
Meanwhile, some observers believe there's a much larger, more ominous analogy that deserves investors' attention: Japan.
Despite myriad social, economic and political differences, major U.S. stock proxies have produced chart patterns in recent years that are eerily similar to those produced by Japan's Nikkei 225 after its bubble burst in 1989. Those worried about a continuation of the trend say the differences between the U.S. and Japan aren't as important as the similarities; most crucially, the penchant of investors to act in certain ways before, during and after financial market manias.
"We may not be exactly like Japan, but you wouldn't know it from looking at the charts," David Nichols, editor of
21st Century Alert
, recently opined. "When the markets are decoupled from reality -- as in a bubble and its aftermath -- then price action itself is the principal driver of future price action."
However you feel about the Japan scenario, and many experts dismiss it, we should know relatively soon whether it's going to continue. For if the similarities hold, the U.S. stock market is in for a very painful fourth quarter. More crucially, the Nikkei hit a 20-year low just last April, so the implications of continuing to follow Japan's postbubble patterns are quite serious.
Back on July 8, Nichols suggested that if the Nikkei analogy continued, the
would suffer a "multiweek correction" of about 10% that would bottom on Aug. 6. In hindsight, that forecast was pretty accurate: From its July 15 intraday high to its intraday low on Aug. 8, the Comp fell 7.3%.
"Such a pullback would be followed by a rally back to the
July highs in August and September, and then the 'big one' hits with all its fury in the fourth quarter," Nichols wrote.
In late 1993 and early 1994, the Nikkei suffered a sudden drop of about 25%. "Such a move would take the
to new lows under 750, provided there isn't significant upside
beyond 1015, which this pattern is not calling for," he concluded. "Now is not the time to succumb to the bullish cant but to instead plan on taking the opposite side of the crowd -- right when few are even considering it."
I was unable to reach Nichols for additional comment. But I did have a lengthy
conversation with Didier Sornette, professor of geophysics at UCLA and author of
Why Stock Markets Crash
Tread on the Tiger's Tail
In September 2002, Sornette coauthored a
paper that detailed a "remarkable similarity in the behavior of the S&P 500 from 1996 to August 2002 and the Japanese Nikkei from 1985 to 1992."
A key element to his understanding of the similarities is that there are forces endogenous to financial markets, wherever they are domiciled.
"By looking at stock market prices of many markets, different countries over several centuries, we found markets are not always as efficient as academics would like," he said in an interview last week. "Investor psychology, overconfidence and interaction
among investors play a very important role in shaping the dynamics of stock markets."
Partly on the basis of parallels between the Nikkei and S&P, Sornette forecast last September that there would be an "overall increasing market" until the end of 2002 or beginning of 2003, followed by a "strong descent" into the first quarter of 2004.
Sornette admitted the market "hasn't been completely kind" to his forecast, attributing a delay in the rally's full onset to uncertainties about the war. Now, however, the market is back in sync with his expectations.
In terms familiar to followers of technical analysis, Sornette described the market as being in a "topping pattern," which he believes will soon give way to a "slow acceleration toward negative trends" that won't end until the summer of 2004. To be clear, he's not predicting a crash but a change of trend toward weakness.
As noted above, a more gentle but sustained decline in the coming nine months (or so) would not follow the pattern set by Japan's Nikkei. "We do not take rigidly the analogy between the Nikkei and the U.S.," Sornette said. "There are similarities, but I'm cautious in using the parallel."
Qualitative similarities between postbubble Japan and today's U.S. markets, include "a bubble preceding an antibubble, strong speculative and herding
activities, with the same fear and herding in the antibubble regime, and some problems with bad loans or bad accounting," he said. "But there are differences, and these differences can be detected," including U.S. investors' greater propensity for "hair-trigger" reactions to any "news." (The term antibubble was inspired by the concept of "antiparticle" in physics, he explained. Just as an antiparticle destroys its sister particle, an antibubble is both the same and the opposite of a bubble; it's the same because similar herding patterns occur, but with a bearish vs. bullish slant.)
On a quantitative basis, there are "serious differences" between the Nikkei and U.S. averages, he continued. Thirty months after the Nikkei's top on Dec. 31, 1989, the Nikkei had "started to shift to another antibubble regime, while no such shift is yet detectable after more than three years" since the U.S. market peaked. (Sornette expects to publish an updated analysis of the comparison shortly, perhaps as early as Tuesday.)
The similarities between the Nikkei and U.S. market are part of the "search for universals" that allow scientists to develop theories about "repeatable occurrences," Sornette said. But, "I am not a proponent of a superposition of the two time series. It is clear to us that their future will be different," he added.
Dissention in the Ranks
Comparisons to the postbubble Nikkei were more common in 2000 and 2001. One prognosticator talking about it back then was Don Hays of Hays Advisory group, as reported
here. Ironically, Hays doesn't seem worried about much of anything these days, believing that a new bull market began last October and that the current consolidation will end shortly "before it takes off again."
The Nikkei analogy is "not appropriate economically, and I haven't been correlating the
current market action according to that," Hays said in an interview last week.
Other experts in investor psychology also took umbrage with the Japan scenario.
"There's probably some truth to say people react to similar cataclysmic events similarly
but the similarities
between Japan and the U.S. aren't that awesome to me," said Terrance Odean, associate professor at the Hass Business School at the University of California, Berkeley.
Among other commonly cited differences between Japan's experience and ours, Odean noted, is Japan's humongous real estate bubble in the 1980s, from which banks there are still saddled with bad loans.
Furthermore, worrying about a repeat of Japan's postbubble blues "suggests things are more deterministic," he continued. "Decisions made here
since 2000 could leave us in a bad way economically, but it's not an inevitable process we have to follow Japan."
Again, we should know relatively soon if the debate over whether the U.S. is following Japan's example still has merit.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.
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