Lessons From Market Crises
Welcome to the 68th Pari Passu newsletter.
Over the last few months, we covered very technical lessons including Class Gerrymandering, Contingent Convertible Capital Instruments (CoCos), and Reverse Dutch Auctions. This week, we are taking a step back and we are going to dive deeper into a less technical topic: market crisis. We will learn about the 3 major types of crisis each with a historical example and identify the general lesson to be learned from it.
The reason we should study market crises in the first place is to gain an understanding of the financial world's cyclical nature and the recurring themes that define it. While the below lessons might seem easy and intuitive, cycle after cycle, smart investors keep falling into the same traps.
The wisdom of Mark Twain, who famously said, "history doesn’t repeat itself, but it often rhymes," is particularly apt in this context. By examining historical patterns and crises, investors can develop an informed perspective on potential future outcomes.
If you’re going to invest in stocks for the long term, or real estate, of course, there are going to be periods when there's a lot of agony and other periods when there's a boom. I think you just have to learn to live through them.
Charlie Munger
Introduction
Throughout the timeline of humans and the history of the financial system, there have been extraordinary booms and busts that have rippled across generations even up to this day. Before we study market crises at various points in history, it is important to define exactly what we are looking for. Put simply, a market crisis is a shock to the price of assets. However, as we go on to look at different market crises, we can see that there are different types:
The Market Bubble - where the quoted price of assets outstrips the fundamentals
The Financial Crisis - an extended period of easy monetary policy and loose oversight
The Macroeconomic Trigger - a crisis that is based on macroeconomic events
Japan: The Market Bubble
Japan's market bubble of the late 1980s stands as one of the most extraordinary in history, both in terms of its sheer scale and the prolonged recovery period that followed. The magnitude of this bubble was so immense that at its peak, the Imperial Palace in Tokyo, the residence of the Emperor of Japan, was reported to be valued more than the entire state of California – a fact that seems almost unfathomable. This period in Japan was marked by an unprecedented surge in asset prices, with the Japanese stock market experiencing a staggering 900% increase in the 15 years leading up to the bubble’s peak. The roots of this market bubble can be traced to a combination of factors, chief among them being the aggressive monetary policy pursued by Japan's central bank. This policy fostered an environment of easy money and low interest rates, fueling a speculative frenzy in both the real estate and stock markets. The bubble reached its zenith in 1989, with the stock market's astonishing PE ratio of 60, reflecting a market severely detached from underlying economic fundamentals.
The turning point came when the Bank of Japan, recognizing the unsustainable nature of this growth, started raising interest rates and tightening financial conditions. This shift acted as the pin that pricked the bubble. The aftermath was a prolonged economic stagnation, often referred to as the "Lost Decade," which stretched from 1991 through 2001. During this period, Japan's economy was characterized by slow growth, price deflation, and a banking system burdened with bad debts. From the market's peak at the end of 1989 to its eventual trough in 2003, the journey was tumultuous, marked by a series of rallies and setbacks. Ultimately, the market fell by 80%, erasing a vast amount of wealth and leaving a lasting impact on the Japanese economy and investor psyche.
During Japan's lost decades, the country grappled with a complex set of economic challenges, chief among them being the struggle to manage the economy and combat persistent deflation. Despite considerable monetary expansion, Japanese businesses and individuals remained unconvinced about investing this influx of capital. This skepticism was rooted in a belief that due to ongoing deflationary pressures, cash would be more valuable tomorrow than today. Consequently, this led to widespread hoarding of cash, as neither businesses nor individuals saw any compelling reason to invest in a market where returns on assets had been elusive for a long time. This behavior transformed into a self-fulfilling prophecy, further exacerbating the deflationary environment.
Importantly, the type of deflation experienced in Japan was demand-driven deflation, which is inherently more concerning.