Why Did the Nikkei Crash? Expanding the Scope of Expectations Data Collection

Abstract

Why did the Japanese stock market lose most of its value between 1989 and 1992? To help us answer this and related questions, we have collected parallel time series data from market participants in both Japan and the United States 1989–1994 on their expectations, attitudes, and theories. Substantial variability within countries through time in these data and, notably, dramatic differences across countries in expectations were found. While no unambiguous explanation of the Japanese crash emerges from the results, we do find a clear relation of the crash to changes in Japanese price expectations and speculative strategies.

The original article first appeared in The Review of Economics and Statistics, 78(1): 156–164, 1996. A newly written addendum has been added to this book chapter.

Addendum: Was the Rise in American Stock Prices in 1990s a Bubble?

This addendum has been newly written for this book chapter.

In the text, we analyzed the crash and subsequent slump of the Nikkei in the early 1990s, utilizing the results of our survey until 1994. In this appendix, using longer results of the same survey we analyze whether the rapid rise in American stock prices in the late 1990s is a bubble.

In Fig. 12.3, we plot the quarterly data of the Dow Jones Industrial Average (DJIA) and Standard and Poor’s 500 Index (SP500), normalizing their values as of the 1995Q1 to be 100. The indices rose gradually from 1990 to 1995, rose rapidly until 2000, and then declined until early 2002. The magnitude of the decline eventually reached about 30 % in the DJIA and about 45 % in the SP500, meaning that in 2 years they lost about half of the rapid gains they had made in the 5 years since 1995.

Fig. 12.3

Stock price indexes and fundamentals

A bubble is often defined as the gap between an asset’s price and its fundamental value. Thus, once we know the fundamental value, the size of the bubble is known. In Fig. 12.3, we also plot the GDP of the USA along with corporate profits. These generally kept pace with stock indices until 1995; a gap a gap then opened up between the two and grew until 2000, suggesting that the rapid rise in stock prices after 1995 may have been a bubble. Fundamental value, however, is the present value of the future earnings of a stock, not the current earnings. If investors have optimistic expectations for future earnings, the fundamental value is high even if the current earnings are low. Thus, we need information on investors’ expectations of future earnings; our survey asks about these.

Our survey asks:

What do you think the rate of growth of real (inflation adjusted) corporate earnings will be on average over the next 10 years?

We plot the result in Fig. 12.4. The average response from 1989 to 1994 was 5.35 %, and from 1995 to 1999 was 5.58 %, implying that expectations did not change much between the two periods. This suggests that the fundamental value did not change dramatically, so that the stock prices in the late 1990s contained a bubble.

Fig. 12.4

Expectations of corporate earnings and inflation rate

Now, let us try to estimate the size of the bubble using some assumptions. Let’s assume that the time discount rate r is constant, that stockholders are aware of all corporate earnings, and that stockholders expect that earnings will grow at a constant rate g. In this case, the fundamental value P is

$$ \begin{aligned}{P}_t=&{E}_t\left[\frac{\pi_t\left(1+g\right)}{1+r}+\frac{\pi_t\left(1+g\right)}{{\left(1+r\right)}^2}+\cdot \cdot \cdot \right]\\ \kern0.72em =&{E}_t\left[\frac{1+g}{r-g}\right]{\pi}_t\end{aligned} $$

(12.1)

Here, π _t represents corporate earnings (profits) known as of period t.

Denoting the expected inflation rate at t as f _t, the expected real growth rate of corporate earnings as ĝ _t, and the constant real discount rate as $\hat{r}$, (12.1) can be rewritten as

$$ {P}_t=\frac{1+{\hat{g}}_t+{f}_t}{\hat{r}-{\hat{g}}_t}{\pi}_t $$

(12.2)

To calculate the fundamental value based on (12.2), we need data on the expected inflation rate, which is asked in our survey:

What do you think the inflation rate (rate of increase in the cost of living) in the US will be on average over the next 10 years?

The result is also plotted in Fig. 12.4, which shows a decline throughout the period, from 4.5 % in 1989 to 3 % in the late 1990s.

Substituting in the survey results for ĝ _t and f _t and the actual value of corporate profits at t-1 into (12.2), and using the assumption that r = 9 %, we calculate the fundamental value P. We then adjust the value so the number at 1989-II equals the value of the DJIA at that time, which allows us to compare the estimated value from (12.2) with the historical DJIA. Specifically, we multiply the estimated fundamental value by DJIA and divide by the estimated value at 1989-II, which implies that the DJIA equaled the fundamental value in 1989-II.

The result is shown in Fig. 12.5. The figure reveals that DJIA was overpriced throughout the period. However, until 1995-II, the overpricing was temporary and was tended to disappear quickly. It was in 1996-I that the gap started to widen; the bubble reached $4000 in 1999-I, whereas the fundamental value itself was $6000. The successive rapid decline until 2002 precisely eliminated this bubble.

Fig. 12.5

DJIA and estimate fundamental value

The estimated result depends on the assumption about the real discount rate. Lower assumed values result in smaller bubbles. If we assume a rate of 7.5 % or 8.0 %, the fundamental value exceeds the actual value of the DJIA at 1995-I and 1998-I and II, implying that the DJIA was underpriced in these periods. Still, the conclusion that a bubble existed in most of the periods, and that its size at 1999-I reached $4000, is maintained under this different assumption.

We should be careful to note that the above estimation depends on various restrictive assumptions, so that the estimation is merely an exercise. In addition to the fact that (12.2) is based on restrictive assumptions, we did not estimate the value of the discount rate, but simply assumed its value. However, there is a possibility that we have underestimated the size of bubble. In the late 1990s, many argued that the US economy went into a new super-productive phase. This argument may have made people believe that future corporate earnings are high. If such a belief was wrong, and their expectation of future earnings was unreasonably high, we should say that ‘fundamental value’ itself, based on such an irrational belief, contained a bubble.