Japan Investor Weekly Summary

China’s Transitory Rare Earth Element (REE) Monopoly

2010-10-24T17:03:00.000-07:00

Now that QE2 being announced at the next FOMC meeting is a given, we see potential for short-term position covering in short USD positions and profit-taking in surging emerging as well as commodity markets. While this is happening, JPY could pull back from 15-year highs and give Japanese equities some breathing room for a relief rally. However, a run back above 11,000 on the Nikkei by next February may be too much to expect, as we just don’t see any sustainable reversal in the race to the bottom for US treasury yields as well as the great shrinkage in US-Japan long bond yields that would support a sustained rally in Japanese equities. Consequently, the trade is buy more emerging market equities and commodities on this possible pullback, and take profits as Japan equities stage a brief relative performance rebound.

The sharp curtailment of rare earth elements (REE) by China has highlighted just how dependent technology-intensive western nations are on what is still a relatively tiny basic materials market of only around $1.2 billion. Be it for environmental considerations as China claims or the desire to save these materials for its own consumption, China’s sharp cutbacks in exports of rare earth elements has market prices of these materials soaring. The faster market prices rise, the sooner China loses is current monopoly on supply, as there is no shortage of potential supply of these “rare”elements.

The two names most mentioned as REE plays are Molycorp Minerals（MCP）, owner of the Mountain Pass mine in the U.S. and Lynas Corp. (LYSCF.PK), owner of the Mount Weld mine in Australia, which combined can supply 25%‾30% of global supply when fully operational. Investors however need to be aware that both stocks have tripled in price since June‾July of this year on the news that China has substantially cut back REE exports, while operations are still deeply in the red. As other REE plays essentially have no product to sell as yet and may not for many years, we view such stocks as speculative plays with little fundamental support at present. In Japan Showa Denko (4004) and Hitachi Chemical (4217) are key suppliers of ceria surry, but this business is too small to dramatically turn around total revenues or earnings even if prices of REE materials are jacked up as much as 300%. Consequently, stock prices have followed the general market for Japanese equities, i.e., steadily waffling lower since April 2010 highs.

Japanese Banks: High Inherent Risk from Bond Market Volatility

2010-10-12T19:53:00.000-07:00

As US and European banking majors were sinking under the weight of on and off-balance sheet toxic assets from the US sub-prime debacle, Japan's megabanks found themselves in the glow of unaccustomed financial health. Ostensibly, Japan's major banks survived the crisis and are generally believed to have restructured their businesses. Yet the stock prices of Japan's big three megabanks continue to tank, in an ongoing bear market that has continued since Japan's excess credit bubble burst in 1990, and aggregate market cap of the big three megabanks is even lower than it was 13 years ago at the depth of the crisis.

Simply put, Japan's banking sector has destroyed trillions of yen of shareholder capital. In November 2007, the combined market cap of the big three was about JPY22 trillion, compared to the combined market value of nine predecessor banks of the three financial groups that totaled JPY27 trillion at the end of December 1997. Further, the recent market capitalization of the three megabanks is JPY11.2 trillion, which represents a total JPY16 trillion or so of destroyed shareholder value since December 1997.

Granted, stock prices of the big three have not gone straight down. As NPLs bottomed and the government stepped in to nationalize Resona Holdings in 2003, the big three megabanks staged a powerful rally. From a combined market capitalization of JPY4.7 trillion in April 2003 to a JPY39.7 trillion high in March 2006, the market capitalization of the big three surged 8.4-fold as Japan's economy staged a recovery and interest rates began to normalize. However, it has been downhill since, with total market capitalization shrinking back to JPY10.3 trillion and stock prices peaking well before the stock market as a whole peaked in mid-2007.

In addition to a shrinking profit base, megabank stock prices have been heavily weighed down by cross-holding unwinding as banks reduce their stock holdings and corporates reciprocate, and repeated "beggar-thy-neighbor" capital calls of between JPY500 and JPY800 to bring regulatory capital up to the levels required by the new Basel Accord. Until a recovery along the lines of that seen in 2004~2006 is apparent, we see minimal upside potential in the major bank stocks.

In their October global financial stability report, the IMF noted significant inherent risks to Japanese banks from a "shock" to the Japanese government bond (JGB) market that causes a spike in JGB yields. Japanese banks remain undercapitalized compared to their global competitors as equity investments are still 75% of tangible common equity for the money center banks, profitability is weak because of the BOJ's QE and net interest margins on loans are at ultralow levels.

Such a spike actually happened in June 2003, when a sharp rise in bond market volatility sparked by investor realization that Japan's banking crisis was under control and the economy was recovering caused banks to re-adjust their assumed risk in their Value at Risk (VaR) models that led them to temporarily dump JGBs, causing JGB yields to surge from an historical low 0.45% to 1.6% in just three months. The bank regulators have been running internal risk scenarios for the regional banks suggesting that such a move would cause bond losses in the trillions of yen for the banks.

A Deflation-Resistant Stock: Is There Such an Animal?

2010-08-15T19:53:00.000-07:00

As the US recovery sputtered, the Fed first cut its forecast for growth and inflation, then Ben Bernnake told us the macro outlook was “unusually uncertain”, and now the Fed has reversed the course set in place to wind down a balance sheet already triple its normal size at $2.3 trillion; trumping the inflation scenario and sending investors scurrying into the deflation camp and fleeing “risk on” trades. Hattip to the deflationists. One could point out that deflationists have not had their prediction (i.e., real deflation) come true for the last 50 years, but rather than fight the tape (and the Fed), now-contrarian inflationists will just have to go with the flow for now i.e., reduce equity and commodity exposure and go long VIX volatility, bonds, gold and cash while waiting for the next turning point. With the S&P 500 failing to hold its 200-day moving average and now testing its 50-day moving average, we’ll have to see if support at 1,060, 1,010 or 900 holds.

For Japan, this means strong momentum for new highs on JPY/USD below JPY/USD80 despite an increasingly expected response by the Japanese government, and downside on the Nikkei 225 of about 11% to the 8,000 level i.e., the opposite of our “next 15 minutes of fame” scenario in which Japanese equities stage a meaningful rally. With Japanese JGB yields having historically been as low as 0.44% and JPY/USD still pushing historical highs, both foreign and domestic investors are likely to keep money parked in JGBs until the deflation hysteria passes. Our point remains however that once JPY/USD peaks, it won’t stay there long. When JPY peaked at JPY79/USD in 1995, it almost immediately began falling, and crashed to the JPY/USD140 level by 1998.

Investors now steeped in deflation psychology are beginning to look to Japan for guidance on what stocks could hold up during a major bout of deflation. We have identified 47 Nikkei 225-constituent stocks that have dramatically out-performed both the MSCI USA and EAFE indices since Q3 1998 during Japan’s deflation. Further paring this down by selecting those that, a) dramatically outperformed the US and EAFE indices, b) have ROCE (returns on capital employed) of over 8% and c) have lower (under 13X) EV/EBITDA ratios, gives us a compact list of 11 stocks that should continue to do well under Japan’s ongoing deflation.

Who Wants to Bet Again on a Cyclical Turn in JPY?

2010-07-26T22:37:00.000-07:00

In November 2009, foreign investors had essentially given up on Japan as a hopeless basket case and JPY was peaking. Around that time, we began suggesting that Japanese stocks had a fighting chance for a decent rally in early 2010, predicated on a weakening trend in JPY to and below JPY100/USD. This “decent rally” lasted until April, when investors got a case of “double dip” and began again to take risk off the table, thereby sending JPY back toward historical highs.

Basically, the strong JPY is only adding salt to the wounds of Japanese equities. If growing concerns of a double dip in the US and slowing growth in Euroland and more importantly China weren’t enough, JPY surging back to JPY85/USD was well beyond what exporters had been assuming in their FY2010 budgets, meaning forex losses on top of the feared weakening export volumes. The strong JPY has been an albatross around the Japanese market’s neck since JPY was trading weaker than JPY120/USD in June 2007, and nearly JPY170/EUR in July 2007. Since then, JPY has surged 42% versus USD and nearly 50% versus EUR. That is a massive swing that even aggressive fiscal stimulus, let alone the anemic countermeasures implemented so far in Japan, could offset.

With JPY now again pushing the JPY85/USD, we are approaching the next fork in the road, i.e, when JPY will again peak out. Since the Nikkei 225 has a high negative correlation of 0.61 vis-à-vis JPY, cyclical peaks in JPY are an ideal time to establish medium-term (i.e., 6 months or so) trading positions in the export sectors, i.e., precisions, electronics and automobiles, as stock prices in these sectors discount currency movements real time. While the turn is contingent on a more relaxed attitude toward global growth and rising, not falling US bond yields, Japanese stocks will again have their brief 15 minutes of fame and outperform their global peers during the next JPY weakening phase. Meanwhile, the market forward P/E multiple is back to 2008 lows, or around 16X.

Conversely, the Nikkei 225 has an even higher positive correlation with JGB yields (0.74), meaning that any new down-leg in JGB yields (ostensibly on more serious concerns about the economic recovery) should be taken as a warning that stocks are also headed for another down-leg, sending investors into an even deeper “risk off” mode.

Strong Yen is Bad News for Japan Stocks

2010-07-19T18:18:00.000-07:00

The financial market commentary recently sounds more like a commercial for Baskin Robbins, i.e., “ double dip!, double dip!”, and equity indices are now fighting historical odds in being able to show positive returns for 2010, while bond returns are outperforming stock gains by the widest margin in nine years as investors scramble to preserve capital from a double dip recession. In our view, however, the risk of a significant selloff from here is limited, despite further growing evidence of a slowdown.

What businesses and investors dislike most about the Euro sovereign issue, China’s tightening, the talk of a double dip, etc. is uncertainty. Take away the uncertainty, and stock prices react positively. A good example is British Petroleum (BP); cap the well, cap the uncertainty, and the stock soars. Another example is Goldman Sachs (GS).

Since China’s Shanghai Composite has taken the biggest hit this year (down 24% YTD), it could be an interesting contrarian play for the next 6‾12 months given the high growth potential China continues to offer. Since China is so important to the supply-demand balance for commodities like crude oil and copper, rallies here are also keyed to what happens with China stocks. Meanwhile, other Asian economies are doing quite well, thank you as are their stock markets, so much so that to a man they are having to tighten monetary policy to get ahead of inflationary tendencies.

On the other hand, while Japan’s Nikkei 225 has declined less than other major markets in 2010, this is merely because it lagged the 2009 equity rally so severely. Declining JGB yields are pointing to downside risk in Japanese stocks. The IMF has warned Japan that it needs to get its fiscal house in order. So what? It’s not as if Japan’s politicians don’t know this, it is a question of being able to execute. The DPJ and Naoto Kan tried to make good on their promise to the world that they would get their fiscal house in order, but look what happened. They were handed a sound thrashing in the upper house elections that is discouraging further talk of austerity, even though everyone, even voters, is very aware that Japan needs to come to terms with its mountain of government debt.

It's A Binary World Now: i.e., Risk On or Risk Off

2010-07-11T21:50:00.000-07:00

Centering on U.S. stocks, equity markets managed a good rally last week from temporarily oversold levels, but it is still too early for an "all clear" sign. Some brave souls in the U.S. were confident enough to state that lows in the S&P 500 have been seen for the year, but we are not ready to bet the farm on such a call, and neither are the hedge funds, it appears. Trading has become binary, i.e., its either all risk trades on (developed market stocks, emerging markets, commodities, high yield debt and commodity currencies) or tin hat trades, i.e., USD, L-T U.S. Treasuries and gold?with JPY and Japanese equities drawing incremental amounts of haven money as well?China in JGBs and European investors in equities because of the good performance seen YTD as far as Euro-based investors are concerned.

While investors appeared more sanguine about Euro sovereign debt and disappointing US employment numbers last week, these and other issues such as the lack of demand in the U.S. housing market have not gone away. The IMF upgraded its global GDP outlook for 2010 GDP but downgraded their outlook for Euroland, emerging markets and Japan in the process while ironically upgrading the U.S. and China's outlook, two areas of more concern as regards the growth scare.

The media polls in Japan are showed another roller coater ride regarding voter support for the Naoto Kan Cabinet and the DPJ on the eve of upper house elections on Sunday. The expectations were that the DPJ would lose their majority, and that is exactly what happened. While the domestic and foreign media saw weaker bonds, a weaker yen and weaker stocks as the market reaction, stocks were actually a little higher mid-day on Monday (+7.2 points) and JGB yields were a little lower (-0.015 points to 1.140%)--i.e., market response was largely muted. While it will now be harder for the Kan Administration to get legislation through the Diet, economic policy was at best muddling through before the elections, and should continue to muddle through after them.

Foreigners over the past two weeks have again become slight net sellers, after a week of buying in the third week of June. Trading volumes for all investor types however are anemic and there is little conviction in either direction?implying that we could continue to waffle for the foreseeable future but not break down decisively below prior February lows, or in other words our "correction and a fairly narrow trading range thereafter" scenario.

Japan: Stock Prices Fall Despite Better Fundamentals

2010-07-04T16:36:00.000-07:00

Equity indices are now fighting the historical odds. In other words, since 1900, when stock prices were lower at the end of January and the end of June, the market ended up having a bad year some 21 times out of a total 26 times. Last week, open speculation about a double dip recession in the U.S., essentially all developed economies and China had investors taking more risk off the table. Two-year U.S. treasury yields hit new lows as a "dark cross" emerged in the S&P 500 50-day and 200-day MAs, and the market index was also showing a bearish head-and-shoulders pattern. JPY back to JPY86/USD has Japanese investors flocking back into U.S. treasuries. Bond returns are exceeding stock gains by the widest margin in nine years as investors scramble to preserve capital.

The growth scare is coming from evidence that the global export-led global recovery is losing steam, as manufacturing growth from China, the euro region and the U.S. slowed in June for the second consecutive month. This just after the OECD revised its forecast in late May for GDP growth in the OECD economies from 1.9% to 2.7% percent this year.

Ironically, Japan's June Tankan reading of Japanese business sentiment was a positive surprise, showing the best positive reading in the sentiment index in two years for the larger manufactuers, with a reading of +1 versus expectations of -4 and compared to -14 in March. The reading represents the fifth consecutive quarter of improvement, and large Japanese manufacturers see further improvement to +3 over the next three months. Profits at these manufacturers are now expected to show a 43.8% rise in 2010 versus a 3.7% decline in 2009.

Unfortunately, foreign investors, who are so instrumental in Japanese stock price formation as they own some 26% of the market and account for 40%~60% of trading value on the Tokyo Stock Exchange, suspect the good news about Japan's economy is a lagging indicator to slowing global economic data, even though the ever-cautious BOJ is moving to revise up its forecast for Japan's GDP from 1.8% to 2.5% for FY2010.

More Downside Risk

2010-06-06T19:21:00.000-07:00

The selloff in the S&P 500 on Friday on the back of steep drops in Southern European equities and new lows in the Euro underscored the view that there is further downside risk in global equities. Global investors continue to reduce risk asset positions and seek gold, the USD and long-term US treasuries for safe haven.

We see nothing on the foreseeable horizon to significantly backstop the Euro sovereign debt contagion. A US-style package of bank stress tests, visibility on potential balance sheet risk and programs to ring fence financial contagion would help, but would be politically time-consuming and in the end may not save the Euro, which is at least going to parity with USD and could still cease to exist in its current form and membership.

While Japan’s economy is showing encouraging signs of recovery as are corporate profits, the Japanese government appears powerless to turn the tide on the strong yen, firstly because prime ministers and their cabinets in Japan are beginning to look like endangered species with average life spans of less than 12 months.

The DPJ has quickly fielded its number two man, Naoto Kan after the sudden resignation of Yuko Hatoyama and the party’s puppet master, Ichiro Ozawa. Because of earlier comments as finance minister about wanting a weaker yen, the emergence of Mr. Kan did create some transitory weakness in JPY/USD, but this is unlikely to last. At the same time, Mr. Kan as a fiscal hawk is expected to press forward with two fiscal consolidation programs that were to be released in June.

However, his socialist-leaning “third way” plan of taxing households to create a big government that re-allocates these tax revenues to welfare expenditures, while admirable from a societal perspective, will do nothing but reduce Japan’s economic growth potential, and may even exacerbate Japan’s waning ability to growth itself out its debt problem over time with a much-needed secular uptick in economic growth potential. As a result, the business and financial community are already abandoning the DPJ to support former reformist financial services minister Yoshimi Watanabe’s of the Everyone’s Party.

A Summer of Discontent

2010-05-30T23:49:00.000-07:00

For the month of May, the Dow Jones Industrial Average tumbled nearly 8%, marking its worst May performance since 1940. Markets are whipsawing by several hundred points intraday, regulators still can't figure out what happened during the flash crash, Euro sovereign risk remains in the headlines, politicians in Europe, the US and Asia add to the uncertainty with increasing regulation, and saber-rattling in North Korea ups the level of geopolitical risk. With all the volatility and uncertainty, the prudent course seems to be to just back away to the sidelines and let the market action itself figure out what the next trend is.

The S&P 500 failed to recover its 200day MA at 1,104.86, after punching down to 1,040.78 or just below February's 1,044.50 low. While the S&P 500's VIX volatility index remains below the Lehman/AIG collapse high of 89.53, it is back to levels seen during the Bear Stearns and Fannie & Freddie collapses, and before that, the Asian Currency, LTCM and 9/11 crises. Volume has surged as traders/investors try to figure out if they want to be bearish or bullish.

With virtually every major US and global equity index as well as commodities and other risk trades-- having dropped below their 200d MA, the prognosis is more technically bearish than it was at the end of the previous week. While the Nikkei 225 rallied 120 points on Friday, it is now off 17.2% from an April 12 11,351.55 high, and trading well below its 200d MA, which is still well above 10,000. While the Japanese economic data is actually looking upbeat and consumer as well as corporate sentiment is improving, stock prices are more about foreign investor risk attitude, which for the past three weeks has been "sell Japanese equities first and ask questions later"

Perhaps the best scenario for now is that markets remain volatile and choppy as downside support levels are confirmed over the next several months i.e., through the summer, which is the old "sell in May and go away" routine. Our main scenario remains for an extended trading range as stock markets transition from excess liquidity to economic and earnings-driven fundamentals, while the probability of a break down to new lows and resumption of a secular bear market is not zero.

Bear Tracks

2010-05-23T16:21:00.000-07:00

The S&P 500 was the last market to crack. The unraveling of the global market recovery actually began with the Shanghai's breaking down through its 200-day moving average. While the Shanghai composite peaked way back in September, it didn't completely break down until April-- then came the Euro, Euro stocks, emerging markets, copper/commodities, the US financials and then the S&P 500?all like a house of cards.

The prognosis is bearish. At the low last Friday, the S&P 500 took out its "flash crash" low of 1,065.79 and is just barely above the 1,044.50 February low. Beyond that, its back to 900. As it stands now, the index has followed virtually all other risk trades in breaking down below medium-term support, which indicates we are now in the so-called interim correction we were talking about way back in February. Listening to the chatter in the blogs and among the talking heads on TV who have been talking to their hedgie and big institutional contacts, investors are spooked and could stampede at any time, if they have not already begun to do so.

The economic news in Japan over the past few weeks is actually quite positive, not that anyone cares. Foreign investors remain the primary driver of Japanese stock prices, and they have been net sellers of Japanese equities for the past three consecutive weeks. Working against Japanese equity sentiment is the sharp uptick in the JPY index, both against EUR and USD, as yen carry trade sees an unruly reversal. This only adds to concerns that slowing Euro and China economies will put a crimp in Japan's now-buoyant exports.

That said, Japanese equities probably have less potential downside than other developed as well as emerging markets, simply because Tokyo stock prices haven't gone up as much, and the long-term prognosis (i.e., debt and even more debt) was already pretty glum. Since domestic investors are not piling into higher yielding overseas currencies or stock markets anymore, JGB yields have quickly lost about 10bps as cash-rich domestic investors park their excess cash in JGBs for the time being. As a result, JGBs have also become somewhat of a safe haven, if only for domestic investors.

Dow 11,000, Emergent Japan and Reputational Risk

2010-04-19T00:43:00.000-07:00

US stocks got a nasty surprise last Friday as the SEC slapped Goldman Sachs with civil-fraud charges. From our corner of the world, it looks political. Political for the SEC to restore their reputation as the cop of the Street, political for legislators trying to implement more control of dark pools of capital sloshing around financial markets, political for Main Street to vent their anger over having to pay for the great recession while those who perpetrated not only get bailed out, but are back to receiving multi-million dollar bonuses while 15 million are unemployed, and political schadenfreude for those firms that crashed and burned during the financial crisis while Goldman apparently dodged the bullet.

Goldman's stock price took a 13% hit on Friday, and investors are asking themselves if this will derail the "meltup" rally since February that was being led by the financials. In other circumstances, Goldman would end up writing a check for whatever they are fined by the SEC without admitting to any wrongdoing, while the White House (and SEC) claims victory. Given the current political climate in the US, it may not be that easy this time.

However, we see parallels between Goldman and Toyota in that two of the most respected companies in their respective industries have some serious reputational risk. In the case of Toyota, the recall debacle triggered a 23% selloff that the stock has yet to recover from, but has not done any particularly deep or lasting damage to the Toyota brand even though it could end up costing the firm upwards of $5 billion.

Having just survived one of the most serious financial crises and economic recessions since the 1930s, the Goldman case is unlikely to be anything other than a temporary hiccup to the global equity market recovery. While the news caused some knee-jerk buying of the yen and general profit taking in risk trades, it is unlikely to be a game-changer in terms of the market trends that were in place before Friday of last week. In other words, we see foreign investors continuing to restore their exposure to Japan as they avoid Euro sovereign risk and look to Japan as a cyclical play. While there may be some knee-jerk profit taking in Japanese banks and broker/dealers, the major financials in Japan were already lagging the rally in Japan and virtually ignoring the rally in US financials.

Japan Beginning to Outperform

2010-04-06T19:09:00.000-07:00

In a word, the economic news is good and very supportive of risk trades. The March JP Morgan global PMI was 56.7 versus 55.4 in February, near a 6-year high. Growth of production and new orders regained most of the momentum lost in February, while global trade volumes rose at a survey record paceh, was the JP Morgan comment. US employment is increasing the most since May 2007.
Shorter-term, we donft think USD rally is over yet, either against major trading partners, JPY or EUR. Even savvy Goldman and Citigroup ended recent bets against USD after losing on the trades. Our guess is that USD does have a good chance of rebounding to the 90 level. We therefore remain long USD, underweight EUR and JPY. After insisting that JPY was going back to JPY85/USD, foreign currency strategists and traders have capitulated and are now moving to short JPY.

The Nikkei 225 is at an 18-Month high and comfortably back above 11,000, with increasing talk of 15,000 within 2010. For a while, it seemed there was essentially no positive catalyst for Japan. However, the Hatoyama Adminstrationfs stimulus measures seem to have brought about a welcome perk-up in domestic consumption, Japanfs exports are surging off very low YoY comps, and the BOJ is also now playing ball by offering some JPY20 trillion of liquidity for corporations. Business confidence as measured by the BOJ Tankan DI (diffusion index) is showing a marked recovery from a very deep trough of -60 in early 2009. The March Tankan survey is also pointing to a sharp 49%+YoY rebound in corporate profits for large manufacturers, a historically high recovery rate.

By sector, investor attention is now shifting to capital expenditures, selected retail and shipping stocks. While exports and production of automobiles and electronic equipment were the hardest hit by the global crisis, autos, consumer durables and electronic components have led the recovery in Japanfs production, while capital goods have lagged. Given the sharp recovery in corporate profits, however, there are already signs that once-moth-balled capex plans are being dusted off and re-considered. Japanese shipping stocks have lagged the rebound in shipping rates as investors discounted massive swings from historical profits in FY2007 to deficits in FY2009. Earnings however are now in a sustainable recovery mode.

Currency Winds Now Favorable for Japan Stocks

2010-03-28T17:06:00.000-07:00

The melt-up in US equities comes with a noticeably stronger USD and rising treasury yields. The inverse relationship between a stronger USD (risk avoidance proxy heretofore but now a recovery/normal monetary policy indicator now) and stocks is transforming into a more constructive positive correlation. At the same time, investors need to watch US bond yields, as too steep a rise combined with Fed extraordinary monetary policy exit strategies could blow the lid off mortgage rates and hobble stock prices.

Conversely, commodity prices are now beginning to lag and with them, emerging markets. China stocks have veered off course with all of the pronouncements of an imminent popping of an excess credit bubble and US trade friction. Whether true or not, investors are now backing away from China stocks, and concern for China is hobbling commodities along with the stronger USD. Waning commodity prices are in turn hobbling emerging market stocks, which some believe have come too far, too fast and are fully valued for the time being. However, investors fleeing Euroland and China are re-allocating funds to other Asian markets.

As we expected, the JPY/USD rate is breaking through JPY90/USD toward JPY100/USD. While JPY is still appreciating versus EUR, the trade-weighted JPY index has also broken through 40-week MA support. Thus the currency winds are now favorable for Japanese stocks. If the US does succeed in pushing China to allow the Yuan to appreciate further, this will also help restore competitive advantage to Japanese exports and provide further support for stocks. Supply-demand wise, foreign investors remain the primary drivers of Japanese stock prices, which is something investors need to continue to monitor.

As we said last week, however, the case for Japan is not a top-down buy according to a market-cap weighted index scenario. One look at the poor performance of Japan's banking sector should be evidence enough that the investment story for Japan is not a passive top-down story. Rather, it is a bottom-up stock selection story,concentrating on smaller capital companies with strong and growing businesses in Asia/emerging markets, where valuation-changing growth lies.

Don't Buy Japan, Buy (Smaller) Japan Stocks

2010-03-23T19:30:00.000-07:00

Last week, we outlined a contrarian case for Japan more specifically, for Japan stocks. As countless commentators never tire of repeating, the top-down story for Japan, well...basically sucks, for the reasons just about everyone has heard umpteen times. Last November, however, we suggested Japan did despite the poor top-down outlook have a fighting change at outperforming in 2010, largely because of a weakening in JPY against USD and Euro against the backdrop of recovering global trade.

This view was predicated on a significantly weaker yen, instigated by a) waning risk aversion, b) a significant divergence in US and Japan monetary policy, i.e., the Fed moving to tap the brakes while the BOJ was still trying to find the accelerator. The latest move by the BOJ and the Fedfs shutting down of the last of its liquidity programs were supportive of this view.

But the boost from additional easing measures by the BOJ was only fleeting, and investors were soon back to worrying if Greece will have to ask the IMF for help and China tightening, while bidding up JPY against the Euro. A downgrade of the property sector by Morgan Stanley didnft help either, as it came as the Ministry of Land, Infrastructure, Transport and Tourism was announcing that nationwide property prices as of January 2010 were falling 4.6% YoY for the second year, with commercial prices in selected central Tokyo sites dropping 25%~26%, with idle office space rising in Tokyofs 23 wards, Osaka and Nagoya to 6%, 10% and over 12% respectively.

That said, it appears that JPY/USD is being set up for a significant move out of what has been an increasingly narrow trading range, and the MSCI Japan index has been outperforming the World, EAFA and Emerging market indices for the past three months in clocking a 5.7% gain, while the Japan Value index has returned 6.1% during the same period. While fund flows into Japan stocks so far have been in the larger cap companies, the JASDAQ (smaller cap growth) currently offers the lowest P/E multiple among TSE 1, TSE 2 and JASDAQ, while TSE 2 offers a PBR of 0.68X, or a 32% discount from stated book values.

The Contrarian Case for Japan

2010-03-14T17:07:00.000-07:00

Japanese benchmark stock prices are still trading at levels only around 1/3rd highs set over 20 years ago, domestic institutions are unloading cross holdings and foreign investors are passing Japan for growth opportunities in Asia. Basically, investors have become severely apathetic about Japanese stocks, much like was seen in US stocks in 1979 and in commodities like gold in 2000.

Japan has upwards of 200 companies trading for less than the cash on their books. Compared to PBRs and PSRs in other countries of 3~2 times, Japans smaller companies are selling at average PBRs and PSRs of 0.40X and 0.83X respectively. Japans smaller companies in aggregate would have to rise 5-fold to be on par with global peers. These stocks are basically the invisible men of the stock market, with little domestic or foreign institutional holdings, no research coverage and management that barely tolerates outside investors.

History never repeats exactly, but it does rhyme. At the height of investor apathy toward US stocks, the whole S&P 500 was selling at a book value less than 1.0X. Then, the US economy was floundering on the rise of international competition, the Vietnam War, the oil shocks of the 1970s, a plunge in productivity, the hollowing out of American manufacturing, a series of currency crises and, most importantly, runaway inflation.

Investors buying the S&P 500 in 1979 would have more than tripled their money if they held until Black Monday 1987. They would also have quadrupled their money in gold if they bought at the height of apathy toward commodities in 2000. The moral of this story is that major secular trends can take decades to run their course i.e., about 19 years, 11 months and 24 days longer than most professional investors are willing to tolerate.

While we seriously doubt there are any investors besides Warren Buffett who are willing to buy and hold for 10 years given the current backdrop of uncertainty, we just may be on the cusp of a major turning point for Japan?i.e., either Japan sees a major fiscal crisis in the next 10 years (and we get another global financial crisis), or the benchmark indices are three times higher than they are today. It could even be both of the above.

BOJ: Getting With the Program?

2010-03-10T00:17:00.000-08:00

Last week, there was a lot of speculation about the BOJfs next moves. While resolutely ruling out further outright purchases of JGBs and an explicit inflation target as is being demanded by the Hatoyama Administration, the BOJ will reportedly seriously consider additional liquidity provisions to push down Japanese short-term rates. In addition, the MOF has added some JPY5 trillion to its borrowing limit for forex intervention.

With 3-month JPY libor rates now again below USD 3-month libor rates, the carry trade borrowing advantage could again shift away from USD as the Fed continues to implement its exit strategy, to JPY or even GBP. What this implies is that the forces are aligning for significant weakness in JPY versus at least USD. As we have been pointing out, JPY strength versus USD and now Euro has been a significant impediment to a stronger recovery in Japanese stock prices.

While the BOJfs actions, if forthcoming, will work to push short-term rates (and JPY) lower, this alone is insufficient to eradicate entrenched deflation from a continuing JPY30 trillion domestic supply-demand gap and therefore domestic deflation. For Japanese stock investors desperate for some good news, however, last week was a breath of fresh air.

On the other hand, the Hatoyama Administrationfs ability to implement fiscal stimulus is severely limited by already alarmingly high government debt. The solution to Japanfs deflationary JPY30 trillion supply-demand gap is therefore more likely to be a combination of a weaker JPY, feed-through effects from an export sector production and profit recovery, and offsetting inflationary pressures from price hikes in steel and other basic materials as the global supply-demand balance for these products tightens.

In other words, the way out for Japan is a stronger recovery in global trade?particularly with Asia, and improved profitability on this trade with renewed weakness in JPY exchange rates. Ostensibly, while a renewed commitment to domestic restructuring and consolidation as well as policies to encourage FDI (primarily M&A) are longer-term solutions to the structural malaise in Japanfs domestic economy, we would not hold our breath in anticipation.

Japan: The Focus is Exports to Asia

2010-02-28T17:31:00.000-08:00

Despite all of the disparaging remarks foreign investors make about Japan, rumors of asset managers exiting from Japan stocks totally, or professing little interest in Japan as an investible market and having little confidence in Japan's announced GDP numbers, foreign investors en masse continue to be net buyers of Japanese equities.

One reason is that Euroland is looking even worse these days, with GDP growth in the region expected to limp along at 0.7% in 2010 coming off one of the most serious global recessions in the post war period. Further, the Euro sovereign debt issue is not likely to be solved that easily.

However, weekly net foreign buying in the JPY100 billion range is not enough to ensure a positive bias in Japanese stock prices, as domestic banks and corporates continue to unload their cross-holdings of Japanese stock to meet more stringent BIS bank capital requirements, and in preparation to adopt International Financial Accounting standards, particularly comprehensive earnings reporting, which will include market gains/losses on securities held.

Last November, investors (including yours truly) began to suspect that diverging monetary stances between the US Fed (exit strategy) and the BOJ (do nothing) would result in a significantly weaker JPY, which would be bullish for severely lagging Japanese equities.

Some scenarios had JPY weakening to below JPY100/USD by March 2011 and to JPY110/USD by March 2012. Combined with an Asia-led export recovery, such a move could push the Nikkei 225 to the 12,000 level.

By February 2010, however, foreign investor enthusiasm/interest in Japanese stocks had already waned. Japanese stock prices virtually ignored the headline 4.6% annualized growth in Japan’s GDP for the October-December 2009 quarter. With 20:20 hind vision, the catch-up rally from last November was already discounting this uptick in growth.

On the other hand, we believe the sharp recovery in exports on a strong rebound in Asia demand is not being fully appreciated in current stock prices.

Fed's Move is Incrementally Positive for Japanese Equities

2010-02-22T22:26:00.000-08:00

Last November, we became more upbeat on Japanese equities from a cyclical perspective because Japanese stocks had become significant latecomers, and we saw the Fed beginning to implement its exit strategy while the Japanese government (and, reluctantly, the BOJ) was still fumbling for the accelerator to a sustainable Japanese economic recovery.

Most global investors agreed, pouring a net JPY2.8 trillion into Japanese equities from November into the New Year. In the last week of January and first week of February, however, foreign investors turned modest net sellers in a global dash-for-cash to trim risk profiles to account for Euro sovereign risk. But they should now begin returning to Japanese stocks as JPY begins to weaken again.

This is because the Fed’s move to gradually implement its exit strategy by raising the discount rate by 25bps is modestly bullish for Japanese equities because it will work to weaken JPY/USD rates. In addition, Japan’s exports to China and Asia are again surging off very low YoY comps, which noticeably boosted Japan’s October-December 2009 quarterly GDP.

On the other hand, Japanese equities still face domestic headwinds, not the least of which is the Hatoyama Administration and the BOJ singing off of different song sheets as to how to eradicate entrenched deflation in Japan.

Further, domestic financial institutions and corporates can be expected to continue dumping their trillions of yen in cross holdings, as the banks continue preparing for more stringent BIS capital requirements, and corporates move to adopt new international accounting standards. In addition, broker/dealers continue to unwind substantial amounts of Japanese equity prop positions.

That is why we use "incrementally positive". So far, these cross-currents have kept the Nikkei 225 in neutral territory, or right at 10,000 and 200-day MA support. If the Fed moves push JPY/USD a few more yen toward JPY100/USD, however, we would expect to see a commensurate positive reaction in Japanese equities, particularly among those stocks most sensitive to Asia demand and currency exchange rates.

Central Bank Exit Strategy Jitters

2010-01-24T02:32:00.000-08:00

Private sector economists, the OECD, IMF and World Bank continue to revise upward their growth forecasts for 2010 and 2011. Ironically, however, the better the economic news, the greater the risk of an interim correction, as global equity and commodity markets shift gears from being driven by extraordinary excess liquidity to being driven by GDP and corporate profit growth.

Since China was among the earliest with substantial stimulus that has not only re-ignited GDP growth but has also sowed the seeds of potentially damaging credit, property market and stock market bubbles, it should be the first to transition from excess liquidity. Other central banks particularly in emerging markets and Asia, will be watching how this unfolds closely, because they are the next in line to attempt the same shifting of monetary policy gears.

While it is increasingly clear that the worst of the global financial crisis and deep recession is over, the next six months could be a delicate time for financial markets, depending on how successful central bankers in these countries manage the transition, and threats of stricter US bank regulation will add further confusion.

Conversely, the developed economies Europe in particular are further behind on the monetary policy transition curve. That said, PIMCO's view of "the new normal" is looking increasingly less likely, thus the confidence in global equities over bonds despite the high perceived risk of sovereign defaults in Greece, Argentina, Russia, Ireland, Portugal, Italy, Spain and Mexico in that order.

Meanwhile, Japan is still trying to find the accelerator i.e., monetary and fiscal policy is still in a double dip prevention mode. This is setting up JPY to resume its role as the source currency for the global carry trade, which could push JPY to JPY100~JPY110/USD over the next 12 months. As our scenario for better relative performance from Japan in 2010 is essentially a forex call, i.e., this dynamic is good news for Japanese equities despite the fact that Japanese equities would also see short-term weakness during any meaningful interim correction in global equities and commodities.

China Taps the Brakes; Japan Looking for the Accelerator

2010-01-18T22:12:00.000-08:00

The steep yield curve, falling bond spreads, the S&P 500 VIX and lower rated as well as emerging bond prices all collaborate what the investor surveys show, i.e., that investor confidence is back to pre-crisis levels two years ago. More economists are suggesting the US economy could see 5%~6% PA growth. At some point, this could cause a temporary “inflation scare” with traders discounting Fed rate hikes long before the Fed is ready to actually move.

In China, massive government stimulus early in the crisis has produced the desired result, i.e., China’s growth is back above two-digits versus initial forecasts of growth more like 5%~6% PA. However, massive loan growth to supercharge domestic demand and offset the drop-off in imports needs to be contained for China to fend off re-emerging bubbles. Thus China is now “tapping on the brakes” to reign in this speculation. Unlike the past, we don’t see China slamming on the brakes so hard it throws all the passengers through the windshield.

Concern about US and China central bank course changes could well trigger an interim correction in both markets, but we believe these corrections will not be serious—i.e., not cause a resumption of the “old” bear market.

Meanwhile, Japan is still trying to find the accelerator. The developing DJP political funding scandal could actually make the yen incrementally weaker if it threatens to delay legislation on supplementary budgets aimed at ensuring no double dip in Japan’s economy. The 10% or so reversal in JPY/USD has already ingnited a 20%-plus rally in the Nikkei 225, driving outperformance for December and so far this month. As long as JPY remains weak or benign, the Nikkei 225 rally can continue.
This rally is also being driven by foreign investors, who have piled back into Japanese equities to the tune of a net JPY2.75 trillion since the last week of November 2008 from extremely underweight positions.

Buy Cyclical Japan and Secular Growth Emerging

2010-01-11T22:22:00.000-08:00

The traditional view of investing in emerging markets is that they are highly volatile, illiquid and subject to unforeseen risks such as debt problems, political unrest or natural disasters. Basically, they a like an option on the developed markets, particularly the US, who was often their major export customer.

But the long-term (10 year) performance of emerging markets as measured by benchmark indices shows clearly superior performance that more than offsets the higher volatility. For example, the MSCI EM index in USD has provided a 7.7% return over the past 10 years, versus a minus 1.2% return for the developed world’s markets, and basically flat performance for the developed world markets ex-the US. In other words, while “buy and hold” may be dead in the developed markets, it is alive and well in the emerging markets.

Further, like small cap stocks, emerging markets perform the best in the early stages of recoveries in the developed markets and global trade, and come roaring back from bear market troughs faster than bigger, more mature markets. In 2009, the MSCI EM index produced a massive 75% return versus the “modest” 27% return for the US.
Growing balance of payments surpluses and more sound financial systems are resulting in substantial growth in savings in the developed markets, and the next big future wave emerging markets will be massive urbanization, substantial investment in infrastructure to support this, and a new generation of middle class consumers for Japanese and regional companies to sell to.

Thus our thesis for BRICs/Emerging is secular (top line) growth at a reasonable price. Our thesis for Japan is cyclical bottom line recovery supported by a weaker yen.

However, some Japanese companies are already well on their way to profitably leveraging a shift to Asia/BRICs/Emerging. The Japanese government is only now waking up to this potential, and these are the Japanese stocks we are emphasizing. Look for new policies over the next few months to help Japanese companies capitalize on this emerging market infrastructure and consumer demand.

Some Brightness for Japan in 2010

2010-01-04T22:28:00.000-08:00

While we see a good possibility of the US market seeing a meaningful interim correction as the Fed moves cautiously toward exiting from unprecedented growth in liquidity (monetary growth) and eventually tighter interest rates. The economic recovery, if it is sustainable, should eventually provide corporate earnings fundamental support for modest, one-digit gains in 2010.

Relatively speaking, Japan is now due for a re-appraisal, especially if JPY weakens as we suspect in 2010 with the unwinding of the USD carry trade. Yen weakness could produce a decent, broadly based, “catch-up” rally in Japanese equities centering on the currency sensitive export sector.

But the rising tide will not equally lift all boats. In 2009, the Nikkei 225 managed a 19% gain, while the broader market cap weighted Topix and small cap JASDAQ saw gains of only 5.6% and 0.3% respectively. In other words, only those companies with meaningful global businesses will benefit, as Japan’s domestic economy could well remain burdened by weak consumption, excessive debt and the lack of significant restructuring.

In other words, those companies who successfully orient what has heretofore been successful domestic business models or unique products to structural growth in rapidly urbanizing Asian markets are due for a major investor re-appraisal of their growth prospects, even as their domestic-only peers remain plagued by weak demand and pricing pressures.

In each industry, globalization should continue to cause major realignment, beginning with stock market capitalization, as investors migrate to the new “global demand” blue chips away from old blue chips that refuse to or cannot adapt to the new reality of globalization. This should continue to cause increasing polarization among individual companies.

Japan still has the prerequisites for sustainable growth. What is required is an embracing and positive response to the new globalization instead of a more xenophobic, inward looking approach—i.e., a change in mindset--from individual companies as well as the political and administrative authorities.