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Japan – A Final Goodbye to Deflation

(February 11, 2007)

Dear Subscribers and Readers,

While it is definitely nice to be back (thanks for writing a guest commentary for us last weekend, Bill) to be writing a commentary for all of you, I have to say that taking a whole weekend off last week and staying at the Hotel Del Coronado in San Diego wasn't such a bad experience either.  The “Del,” as they call it, has a rich history going back to its founding in 1888 – and has been visited by ten U.S. Presidents starting with Benjamin Harrison in 1891.  For those who are thinking of visiting San Diego, I urge you to at least pay the “Del” a visit if you get a chance.

Before we continue with the rest of our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,195.83 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,075.83 points

Given that the S&P 500 has been up eight months in a row for the month ending January, and given that February has tend to be a seasonally weak month for the stock market, there is a good chance that the market should continue to experience some weakness over the next few weeks.  Adding more uncertainty is the potential reaction of the Japanese Yen to the latest G-7 Meeting that ended on Saturday.  Barclays has estimated that the Yen carry trade is now at its biggest since 1998 – and subsequently, all it takes is a little volatility in the Yen for traders to start covering their short positions (carry trades only make sense in a low volatility environment).  There is currently no way to tell if certain hedge funds have overextended themselves on the short side of the Yen – but if there is – then any potential fallout resulting from this could potentially spill over to the global equity markets as well.  Readers please stay tuned.

That being said, as of Sunday afternoon on February 11, 2007, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, “brand name” large caps – names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel (Intel is now close to two generations ahead of AMD), GE, and American Express. We are also bullish on Yahoo, Amazon, and most other retailers as this author believes that “the death of the U.S. consumer” has been way overblown.  We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials.  Moreover – judging by what we saw at the Consumer Electronics Show in Las Vegas a couple of weeks ago, there is a good chance we are now seeing a revival of Sony as a great global corporation (barring a global economic recession, the rest of this and the next decade will be known as the age of the emerging market consumer).  We also continued to be very bullish on good-quality and growth stocks in general.

I am also bullish on Taiwanese equities – specifically the iShares Taiwan Index (EWT) as mentioned in our mid-week commentary.   In short, I believe both the Taiwanese stock market and the Taiwanese dollar are extremely undervalued - and that a catalyst for higher prices is just around the corner.  Among the reasons are:

  • Even though Taiwan is a relatively developed country and has a relatively developed financial sector, stock market returns have been dismal over the last five to ten years.  On a ten-year basis, returns are even lower than that of Japan's.

  • Forward dividend yields are estimated by Morningstar to be approximately 5%.  Earnings are expected to continue to grow at double digits.  Both the dividend and the earnings yield are substantially higher than the domestic discount rate, government bond yields, and corporate bond yields.

  • The global capital spending cycle on both hardware and software will accelerate later this year as corporations ramp up their spending on Microsoft Vista and Office 2007 (note that global corporations also have a record amount of cash on their balance sheets).  The adoption of these software items and the adoption of the "solid state hard drive" will substantially drive semiconductor and electronic business in Taiwan.  This has not been factored into earnings estimates.  Note that EWT (the ETF for the Taiwanese stock market is weighted 50% in IT and electronics).

While the current adoption rate of MS Vista and Office 2007 is mediocre at best, it is interesting to note that the reception of Windows 3.0 when it was released in 1990 was also lukewarm at first.  As a matter of fact, a one-year anniversary article published on May 8, 1991 states: “Windows has become a checklist item for hundreds of large corporations, but it remains to be seen how fast top management will agree to massive hardware and software upgrades (in a recession, no less) to achieve speculative gains in white-collar productivity. We think it's more likely that Windows first will have to prove itself in hundreds of pilot projects before we see large-scale adoption of mass-market applications. In the short run, the fastest penetration of Windows products is likely to occur in specialized niches, among individual users who will insist on superior functionality, not just pretty screens.”  As we all know, the rest is history.  As of today, my partner/webmaster, Rex, is already using Vista and loving it.  I will upgrade later this year once the Service Pack 1 is released (crossing my fingers) and once solid state hard drives have been integrated into the various Dell and HP laptops.  As an aside, the most recent dip of MST below $29 is a good buying opportunity, IMHO.

Moreover, the Taiwanese iShares (EWT) are also undervalued relative to the technology/hardware/software sector of the U.S. stock market.  The following table shows a comparison (using forward P/E and other mainstream valuation ratios) between the iShares Taiwan index relative to the SMH, the Morningstar Software Sector Index, and the Morningstar Information Economy Index as of December 31, 2006.

Comparison between the iShares Taiwan index relative to the SMH, the Morningstar Software Sector Index, and the Morningstar Information Economy Index as of December 31, 2006.

As shown on the above table, both the forward P/E and the forward dividend yield of the iShares Taiwan Index are substantially lower than the corresponding ratios of the U.S. technology and semiconductor sector.  Coupled with the undervalued Taiwanese dollar and the fact that earnings growth will also be in the double digits in Taiwan, my guess is that the Taiwanese stock market will surprise on the upside during 2007.

But Henry, the Taiwan iShares are only 50% weighted in technology and semiconductor equipment – how about the rest of the sectors that make up the index?

Good question.  Aside from the technology sector, another sector that has a significant weighting in the Taiwanese iShares is the financial sector (commercial banks and insurance companies) – with a weighting of slightly over 15% (10% in commercial banks and 5% in insurance companies).  One major factor that has been inhibiting the growth of the Taiwanese financial sector has been the Taiwanese government's prohibition of the Taiwanese financial sector to invest in Chinese financial companies or do business in China.  Given the recent successes of banks such as HSBC and Bank of East Asia, however, Taiwanese financial companies have been lobbying (and succeeding) for a rule change.  This legislation change is scheduled to come in the second half of 2007.

Following is a chart courtesy of Goldman Sachs showing the discount that the Taiwanese financial sector is trading at relative to both its Hong Kong and Chinese peers.  As we approach the passing of this legislation (which is by no means guaranteed, of course), Taiwanese financial shares should revalue and “catch up” with the valuations of both its Hong Kong and Chinese peers.

Taiwan financial sector is trading at a widening discount to its regional peers

More importantly, Taiwanese banks and insurance companies also have two distinct advantages in doing business in China vs. financial companies from other countries (including those from Hong Kong):

1) Many Taiwanese companies and individuals who have emigrated to China to do business already have relationships with the incoming Taiwanese banks.  In the Chinese culture, relationships (known as “guanxi”) is everything – meaning that the Taiwanese banks and insurance companies have already gained a strong foothold into China even before they have physically built a single branch on the Mainland.

2) Management that is predominantly Mandarin-speaking.  Again, this will allow them to gain a strong foothold without significant investments – at least initially anyway.  Once the Taiwanese banks are able to establish a strong foothold in China, the rest will come relatively easy (such as hiring foreign currency and risk management personnel – areas that they are currently lacking in talent).

Let us now get to the gist of our commentary and discuss Japan.  First, I want to make one thing clear: All I am suggesting in this commentary is merely that Japan is exiting out of his deflationary spiral – a spiral which Japan has been struggling to exit ever since its stock and real estate market burst in 1990.  While I believe the Japanese stock market (and the Japanese economy) will perform decently this year, I still believe the US stock market is the place to be (if one is solely focusing on the “developed markets”) – either vs. Japan or Western Europe.  In order to make this easy, I will summarize our thesis and reasoning in “point format.”  They are – in no particular order:

1) After exporting deflation for most of 2005 and all of 2006, China is once again exporting inflation – based on the latest Hong Kong re-export prices data.  This not only has profound implications for Japan and the rest of Asia, but for most of the world engaged in foreign trade as well.  In essence, this will take the pressure off most of Asia to intervene in the currency markets to curb the rise of their respective currencies – as well as to allow them to raise prices.  For an exporting country like Japan that has been mired in a deflationary spiral, this is literally a Godsend.

2) Not only is Japan in its longest period of economic expansion since the bubble burst in 1990, but fourth quarter real GDP growth (which will be released this Thursday) is also expected to be respectable at 3.9%.  For 2007, Japan's GDP growth is expected to be slightly over 2%.  Corporate margins are also high – despite continued double-digit increases in capital spending.  The only “fly in the ointment” has been the disappointment growth (or lack thereof) of Japanese consumer spending.  The culprit?  Lack of real income growth despite high corporate profit margins.  I expect this to change going forward as the Japanese labor market continues to remain tight.  In fact, the Japanese unemployment rate has been vacillating between 4.0% and 4.2% during 2006, as shown by the following chart courtesy of the Japanese Statistics Bureau.  Should the Japanese unemployment rate decline below 4.0% in the coming months (right now, there are ample jobs available for anyone that wants them in Japan), then real income growth is pretty much a given:

Japanese unemployment rate 2003 to 2006

3) For the first time in 16 years, land prices in Tokyo, Osaka, and Nagoya (the three largest urban areas in Japan) rose in 2006.  Moreover, the average grade-A office market vacancy rate in Tokyo declined from 1.8% at the beginning of 2006 to 0.3% by the end of the year.  As recently as 2003, the average grade-A office market vacancy rate in Tokyo was 12.3%.  Rents in this market also rose 48% on a year-over-year basis in 2006, on top of a 44% increase in 2005.  Following is chart courtesy of Prudential Real Estate Investors showing grade-A office vacancies in the major real estate markets in Asia:

Grade-A office vacancies in the major real estate markets in Asia

As shown on the above chart, office vacancies in Tokyo and in Japan in general are now at their lowest not only in Asia – but are also at their lowest rate ever since 2000 (not shown).  In an environment of ample liquidity, low interest rates, increased bank lending, higher inflation being exported from China, a tight labor market, and rising real estate prices and rents, there is a very good chance that Japanese inflation will rise in the coming months.  Make no mistake: The Bank of Japan will raise lending rates most probably sooner rather than later – especially if the 4Q GDP growth rate surprises on this upside this Thursday.  While Japanese interest rates will most probably remain relatively low for the rest of this decade, a tightening Bank of Japan will most probably cause a spike in the Japanese Yen later this quarter – serving to correct some of the “imbalances” in the world today as well as ending the Yen carry trade.  Readers please stay tuned.

Before we go on and discuss the most recent action in the U.S. stock market via the Dow Theory, I want to update our readers of a chart we initially posted in our January 14, 2007 commentary (“The Permanent Income Hypothesis”).  In that commentary, I stated that I first got the idea of constructing this chart from Ned Davis Research – who had constructed a similar chart for a Barron's article in late 2006.  At the time, his assertion was that based on this chart, he does not believe the rally in the U.S. stock market is close to “exhaustion” just yet, or in other words, a significant top.  Following is an update of that chart showing the ratio between U.S. money market assets (both retail and institutional) and the market capitalization of the S&P 500 from January 1981 to January 2007:

Total U.S. Money Market Fund Assets / S&P 500 Market Cap (January 1981 to January 2007) - 1) Ratio at a major low at the end of August 1987 - signaling a major top and preceding the October 1987 crash. 2) Ratio touched an eight-year high in October 1990 - preceding a great rally in the stock market whcih would not end until Summer 1998. 3) Ratio vacillated near all-time lows from early 1999 to early 2000 - suggesting the market was hugely vulnerable to a significant decline and a subsequent bear market. 4) Ratio touched 20-year highs! 5) Ratio declined from 16.86% to 16.63% during January. However, the current reading still suggests that the market is not near exhaustion - indicating that the bull market is not over yet.

In our January 14, 2007 commentary, we stated: “Make no mistake: The ratio between money market fund assets and the market cap of the S&P 500 is probably not a great timing indicator – but what it does show is the amount of “cushion” that we have in order to insure against a significant market decline.  While this indicator is telling us that we are closer to the end of the bull market than the beginning of one, it is also telling us that we are not close to exhaustion just yet.  Based on historical experience, this author will not be too concerned until this ratio hits a reading of 15% or below.  Assuming that the amount of money market funds remains the same going forward, the market cap of the S&P 500 has to rise a further 13% before we see such a ratio.  Based on the above study, we will remain 100% long in our DJIA Timing System.

Given that this ratio merely declined from 16.86% as of December 31, 2006 to 16.63% as of January 31, 2007, our thesis remains the same.  That is, the U.S. stock market is still not close to exhaustion just yet – and will most probably not happen until – at the very least – the Dow Industrials hits the 14,000 level or until the S&P 500 hits 1,600.  For now, we will remain 100% long in our DJIA Timing System.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to February 9, 2006) - During the week before last, the Dow Tansports finally managed to close at a new all-time high - surpassing its May 9, 2006 high by closing at 5,006.89 on February 2. During the same week, the Dow Industrials also closed at a new all-time high of 12,673.68. While both the Dow Industrials and the Transports declined this week (the former by 72.66 points and the latter by 87.44 points), both the recent strength and the breadth of the stock market suggests higher prices in the intermediate term. Again, given that February is a seasonally weak month, subscribers should temper their bullishness - but any dips in February should probably be bought and held for the intermediate term.

For the week ending February 9, 2007, the Dow Industrials declined 72.66 while the Dow Transports declined 87.44 points.  For now, it looks like both the major Dow indices is just “taking a breather” and consolidating before attempting to rally  further in the months ahead.  However, subscribers should remember that February is a seasonally weak month – and with the inevitable volatility in the Japanese Yen this week, there is bound to be more volatility in the global financial markets for the rest of this month.  Any correction over the next few weeks, however, should be bought – not only focusing on U.S. stocks but the Taiwanese stock market as well.  

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators bounced from an extremely oversold level of 1.7% in late June to 27.7% for the week ending February 9, 2007.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending February 9, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 28.8% to 29.6% - the most optimistic reading in three weeks. Sentiment levels are now getting close to the extremes we have witnessed over the last few years - so it is now time for the bulls to be careful. In the meantime, however, the intermediate trend is still up but breadth is getting narrower by the day. It is now time to be selective with your stock pickings, especially given that February is a seasonally weak month.

As mentioned on the above chart, the four-week MA of this indicator has been rising consistently since early August – although it did dip slightly from mid November to mid December.  Subscribers should note that last week's reading – at 29.6% - was the highest reading since the week ending January 19, 2007 (and prior to that, January 20, 2006), and is thus now very overbought.  Again, given that February is a historically weak month, don't be surprised if the stock market continues to consolidate in the weeks ahead.  That being said, the intermediate uptrend still remains for now.

Unfortunately, the ISE Sentiment website is having a substantial number of problems this weekend. As a result, I will not be able to update the chart showing the 20-day and the 50-day moving averages of the ISE Sentiment Index vs. the daily S&P 500.  However, I have been tracking the ISE Sentiment readings for most of this week and the readings have definitely been on the pessimistic side (if I recall correctly, the 10-day moving average is in the 110s area).  I will do an update of this chart in our upcoming mid-week commentary.  For now, the latest readings of the ISE Sentiment Index indicate that the intermediate uptrend remains intact – although in the short-run, anything can happen.

Conclusion: Not only is this author still bullish on Taiwan, I have actually gotten more bullish on the Taiwanese stock market over the last few days – given that the Taiwanese financial sector should also surprise on the upside over the coming months.  As for Japan, I believe that the Japanese economy is now holding its own and is officially out of its deflationary spiral – barring any more fiscal or monetary policy mistakes, of course (one can also argue that Japan's recoveries in 1996 and 2000 were short-circuited by the Asian Crisis and the bursting of the technology bubble, respectively).  Not only will this development have a profound impact on the currency markets, but this will also serve to correct many of the “imbalances” in the world as well.  This will also allow the rest of the exporting Asian countries to raise prices – and will indirectly give a boost to the Taiwanese economy as well.

Finally, based on all the indicators I am currently watching (monetary, liquidity, fundamental, technical, valuation, etc.), the intermediate uptrend in the U.S. stock market remains intact.  However, breadth has been noticeably weakening, and given that February has historically been a weak month, subscribers should not be surprised if the U.S. stock market continues to consolidate (or even decline) in the coming days.  For now, we remain 100% long in our DJIA Timing System.

Signing off,

Henry To, CFA

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