Has The "Reverse Bubble" In Europe Started To Burst?

This is from a few days ago, but JPM Japan Equity Strategist Hajime Kitano put out an interesting note on Europe called: The Euro Crisis as a Reverse Bubble.

The basic idea: What we’re seeing in Europe is very similar to what happened in Japan during its bubble, except the opposite.

Bubbles are formed when the market is enthusiastic about an unreasonable valuation yardstick. In the second half of the 1980s, the Japanese stock market focused in a strange way on the so-called Q ratio. At present, the ratio of debt to GDP is acting as the choreographer of a reverse bubble.

As Yale University Professor Robert Shiller points out, ‘The idea that a country goes bankrupt when its debt exceeds 100% of GDP is utter nonsense. After all, debt and GDP yield a ratio in units of pure time. There is nothing special about using a year as that unit’ (Toyo Keizai Weekly, September 3 edition). However, ‘the general public often overreacts to this kind of nonsensical view,’ according to Professor Shiller.

The ratio of debt to GDP is structurally quite similar to the Q ratio in the Japan of the 1980s. The Q ratio (stock prices as a multiple of real net assets) is share price divided by per share net assets plus hidden assets. The more asset values rise, the more undervalued the shares of a company that has hidden assets and/or cross-shareholdings look if hidden assets are included in the numerator. This spawns a virtuous cycle fuelled by the ‘logic’ of ‘buying because prices are rising, and prices are rising because people are buying.’

Meanwhile, if reduction of the ratio of debt to GDP becomes the all-overriding goal, a reverse perpetual motion machine is set into motion. If fiscal spending is cut and taxes are hiked to reduce debt, the economy worsens, and GDP, which forms the numerator, contracts. As a result, the ratio of debt to GDP also deteriorates, which requires further fiscal tightening. The vicious circle fuelled by the ‘logic’ of ‘selling because prices are falling, and prices are falling because people are selling’ shows no sign of coming to a halt.

So is the reverse bubble already bursting?

Kitano offers up this chart:


Photo: JPMorgan

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