Are Western Stock Markets Following in Japan's Footsteps?

After the drama of late July and early August, during which the FTSE fell over 1,000 points, we've had quite a rally.

From an intraday low just under 4,800 the FTSE has gained more than 500 points, hitting a high of 5,370 at one stage on Monday.

We all know the underlying economic problems haven't gone away. But, for now, the panic seems to have.

The question I'm asking myself is: 'Is this bounce of the dead cat variety, or is it more significant?'

Short-selling bans help no one

The French, Spanish, Belgian and Italian authorities may well be congratulating themselves for their ban on short-selling banking shares. They might even feel that they have stabilised markets – and to an extent they have. The ban has coincided with the bounce.

But the ban doesn't change the facts any more than shooting the messenger changes the message. The facts are that too many Western banks have still not marked their bad commercial and residential real estate debt to market; they are still hiding other bad assets off the books; they are playing tricks with their tier one capital; they are overleveraged, and in some cases effectively bankrupt.

More importantly as far as prices are concerned, markets have suddenly woken up to this and started worrying about it.

That so many banks have got themselves into this state is nobody's fault – not even those vile short-sellers' - but their own. And European leaders congratulating themselves on the shorting ban might want to look at how 'successful' it was during the last financial crisis.

On September 18, 2008, the US financial regulator, the SEC, banned short selling in 799 American financial stocks. It gave the US a two-day rally of something like 30% from the lows – not unlike the rally we have just had – followed by a few days of sideways action with a downward bias.

But by late November 2008, two months later, the banking index had halved again.

This time around we have had two days of rally (12 and 15 August) and one day of sideways action with a downward bias (yesterday). So far one is a virtual mirror of the other. It's very possible, even likely in my view, that the ban on short-selling will be no more effective now than it was in 2008.

There is, however, one big difference between then and now. On September 15, 2008 – three days before the ban – Lehman Brothers filed for Chapter 11 bankruptcy protection. The financial world was dealing with the aftermath of that.

This time around no one has filed for bankruptcy. Not yet anyway. But reading some of the independent analysis of banks and their balance sheets across the blogosphere, it looks to me like many European banks are going to need bailing out. And given the difficulty that Europe's leaders have in co-operating on anything, this will be an even more fraught process than it would be in a single sovereign state with control of its own currency.

I shall be sitting on my pot of gold watching how this one pans out with considerable, but detached interest.

The US market is following the Japanese road map

My view for now is that we are not going to see the stock market highs of this year re-tested until we get the next bout of bail-outs, quantitative easing and inflation.

If we get a big European bank going under, we can look forward to the dark days of 2008 once again. But this doesn't have to happen. Look at Japan. Twenty years on and their zombie banks are still feeding.

Of course, the prospect of a Japan-style fate for the West isn't much more appealing than a return to 2008. That's why I'd like you to consider this next chart. I think it's a beauty. But it's unnerving. (Thanks to my colleague David Stevenson who drew it up for me.)

The green line shows the MSCI USA Index, which measures the performance of US large- and mid-cap stocks. The red line shows the MSCI Japan Index, which tracks the equity market performance of Japanese securities listed on the four main Japanese exchanges.

However, we have moved Japan forward 11 years, so that its 1989 high coincides with the US 2000 high. And I have plotted the MSCI Japan in US dollars, so 'the unit of account' is the same.

Isn't it amazing, how similar the anatomies of the bull and bear market phases are, both in magnitude, but even more so in duration?

The initial bull market; the phase where it accelerates and goes exponential; the crash; the recovery high; the second move down and the next recovery high - they all correspond.

Of course, this may be just coincidence. But it may just be how the cycle of boom and bust works. If the green line (the US stock market) continues to follow the path of Japan, then we are in the next bear phase. With the systematic debasement of currency that is going on, it might not be that apparent in nominal terms, but in real terms, I can't say I'm optimistic.

A large part of Japan's problem is that it never really got to grips with the bad debt plaguing its banking sector. We don't appear to be learning from that, instead we are following the same route, creating our own zombie banks that will suck the life out of Western economies.

If we continue on this Japanese path and we are on the next leg down, I suggest the strategy is hang on to your gold (see it is another form of cash), as well as some cash,  keep your portfolio defensive and be prepared to be nimble as we swing between these bull and bear phases.

My latest gold report is now available – as well as looking at ways to buy gold itself, I’ve also tipped some speculative mining stocks that I think are poised to do very well in the coming years, as well as providing some updates on my previous tips. Get your copy of my gold report here.

This article first appeared in Money Morning, the free daily investment email from UK investment magazine, Moneyweek. Sign up here - it's free.