It is fairly obvious to investors that the Nikkei has gotten a bit bubbly of late. It ran up 80% over the last few months on expectations that the multi-decade deflationary cycle that Japan has been fighting could be broken by "Abenomics" and inflation could be created.
It is clear by the drop of 17% in the Nikkei over the last few days that the hopes and expectations of investors in regards to inflation are not being matched by reality.
The trigger for the 17% drop appeared to be related to Fed Chairman Bernanke's appearance before U.S. lawmakers a little over a week ago. In that session, Bernanke repeatedly stated that the central bank cannot affect long-term growth, it can only provide short-term liquidity support in times of crisis. Bernanke went on to state that the long-term solution must be given by the fiscal authorities, not the central bank.
Over the past few months, Japan has been adding about $75 billion per month in liquidity, which is about three times the amount that the U.S. is currently creating, relative to GDP.
Given the fact that Japan has a debt load of about 220% to GDP, its options for fiscal stimulus are quite limited. As Bernanke made clear, central banks cannot create value--they can only create liquidity to fight a short-term crisis.
In order to create inflation, the Japanese government would need to spend money that would get into the hands of the bulk of consumers to the point where they could bid prices up. However, that pesky 220% debt load keeps Japan from doing any major stimulus as it would likely destabilize its extremely delicate bond market to the point of collapse.
It is not that difficult to see how Japan is between a rock and a hard place in regards to what actions the monetary and fiscal authorities can take. The deflationary pressures are very strong and when they try to do a monetary stimulus it just creates a bubble, as seen in the Nikkei over the last few months. If they were to do a fiscal stimulus package of any significance it would add to the high debt load to the point of collapsing the bond market. That reality thing is a pesky little bugger.
Now About The U.S.
Given that the recent Japanese drama of Abe's money printing scheme took place over the past six months or so, it is quite easy to find the flaws and weaknesses of their actions. The 80% rise in the Nikkei has been dramatic, as has been the 17% drop. Somewhat less dramatic but likely more dangerous, is the similarity of the bubble that has been created by the Fed in U.S stocks over the last four years.
Prior to the financial crisis, the U.S. debt to GDP was only about 65%. This allowed for a significant amount of fiscal stimulus in the aftermath of the crisis. This largely came in the form of extended unemployment benefits, food stamps, etc.
Now we have the sequester and significant concerns over the size of the national debt. Cuts to government spending continue.
Since the financial crisis, many investors bought stocks on the premise that inflation would rise significantly as a result of the amount of money being printed by the Fed. The same logic was used by investors in regards to gold. The flaw has been seen in that theory with gold. It appears that it is also being seen in the Nikkei. Now it may be starting to be seen in U.S. stocks.
The Fed's latest inflation numbers show 0.7%--significantly below the Fed target of 2%.
The combination of Japan's demographics in regards to aging, its high debt to GDP, the lack of inflation and the size of the recent monetary stimulus all conspired to show investors a fairly clear picture of the cause and effect of the actions taken in a fairly compressed time period.
The same forces are at work in the U.S. However, our QE programs have been less dramatic in size, relative to GDP and the time periods have been longer in regards to the life of the QE programs (starting in 2009). Our debt load is less dramatic. Our aging demographics are not quite as severe (yet). And, our stock market run has been over the period of four years, rather than six months.
The premise that has caused the stock run is the same in both Japan and the U.S., and it is flawed. The premise is that the government can create inflation. This is proving to be much more difficult that expected.
As the reality of the deflationary pressures make themselves clear and central banks admit their limitations- as Bernanke did about a week ago- I would expect a similar reaction in U.S. stock markets as has been seen in the Nikkei over the last few days.
Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.