Revisiting the 1995 Kobe Earthquake

Since the earthquake off Japan's coast last Friday, the news has been full of catastrophic stories.

Each day brings new horrors, including an ever-greater loss of life, plus the race to prevent further explosions at the Fukushima Daiichi nuclear power plant.

When markets quake
No doubt the global community will do what it can to assist Japan and its people in the aftermath of this horrific tragedy.

In the meantime, worries about the colossal cost of cleaning up after the quake and tsunami have shattered the Japanese stock market. As the world's third-largest economy (after the U.S. and China), what hurts Japan tends to hurt the global economy as a whole.

The Nikkei nose-dives
Here's how Japan's leading stock-market index, the Nikkei 225, has crashed since tremors rocked Japan in the final hour of trading on Friday:

On Monday alone, the 6.2% slide in the Nikkei wiped $287 billion from the value of its 225 members. However, following a third explosion at the Fukushima plant, nervous investors rushed to sell risky assets, causing a near-11% decline in the Nikkei 225 on Tuesday.

At one point last night, things were even worse, as the Japanese market bounced back before closing. Prior to this rebound, the Nikkei hit a low of 8,228, down 1,393 points (14.5%) on Monday's close!

This is the index's lowest level since April 28, 2009, and the first time the Nikkei has dropped below the 9,000 level since September 1 of last year. Clearly, investors are terrified about the earthquake's financial implications for Japan, as well as its human cost.

Lessons from Kobe
When I heard the news of the quake I immediately thought of a similar event: the Kobe earthquake of January 17, 1995.

Although the Kobe quake (magnitude 6.8) was much less severe than the latest quake (magnitude 9.0), it caused widespread damage. The 1995 quake killed nearly 6,500 people and caused damage of 10 trillion yen, or a 40th of Japan's gross domestic product (GDP) at the time.

Of course, the Kobe earthquake also caused the Nikkei to plunge -- but nothing like as steeply as it has in the past three trading sessions. Here's what happened in the immediate aftermath of Kobe:

As you can see, the market reaction to Kobe was quite muted at first, but later led to a 1,055-point dive in a single day. This equates to a 5.6% drop, versus Tuesday's 10.6% fall.

Thus, broadly speaking, the post-quake pattern of 1995 was much less panicked than that seen since Friday. Then again, there were no nuclear accidents in the aftermath of Kobe -- and nothing frightens investors more than the word "nuclear."

Nevertheless, the 17.5% decline in the Nikkei since Friday suggests that Mr. Market may have over-reacted, and we could see a strong relief rally once control is restored at the Fukushima nuclear facility.

A rogue trader collapses
The market reaction to the Kobe quake was worsened by the actions of one man: infamous British rogue trader Nicholas "Nick" Leeson.

As a derivatives broker for Britain's oldest merchant bank, Barings Bank, Leeson was a leading trader of equity futures on the Tokyo and Singapore exchanges. Alas, when Leeson's trades produced losses, he hid them in an error account numbered 88888 (considered a very lucky number in China).

Like a bad gambler chasing his losses, Leeson kept increasing the size of his bets, borrowing tens of millions of pounds a day from Barings' treasury department in London. When the Nikkei fell more than 1,000 points on January 23, 1995, Leeson's Ponzi scheme finally blew up.

When the dust had settled, Leeson had racked up debts of $1.4 billion, forcing the once-proud Barings to sell itself for 1 pound to leading Dutch bank ING. Ouch!

The good news is that, after its initial volatility, the Nikkei gradually crept back toward its pre-Kobe levels (although this was far too late for Leeson). On December 7, 1995, the Nikkei finally notched up its first post-quake gain, 11 months after Kobe.

More market meltdowns?
Looking beyond the human tragedy, there must be some hope for the Japanese economy and its resilient, hard-working, inventive people. For example, the huge post-quake rebuilding effort should boost the fortunes of Japanese construction and heavy-equipment firms, as happened in 1995.

Also, it's worth noting that Kobe was a major economic region in Japan, whereas the latest quake mostly devastated coastal areas, with the tsunami washing over large tracts of farmland, rather than factories.

No doubt the Bank of Japan (BoJ) will do what it can to cushion Japanese shares and its currency against further falls. On Monday, it made Y21.8 trillion ($265 billion) of extra liquidity available to financial institutions, as well as doubling its quantitative-easing (asset-buying) program to Y10 trillion.

Nevertheless, the BoJ must act swiftly and do even more to stimulate economic growth, especially with the country facing the twin headwinds of deflation and a strong yen. Similarly, the Japanese government is poised to announce an emergency stimulus package aimed at shoring up the economy.

Cliff doesn't own any of the companies mentioned. For more from Cliff D'Arcy, click here. Follow The Motley Fool on Facebook.