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Japan’s Relative Strength Improving

(April 9, 2009)

Dear Subscribers and Readers,

The horrible news and statistics keep on emanating from Japan.  For example, Japan's “Big 3” automakers, Toyota, Honda, and Nissan have all seen their global sales plunge as a result of declining US demand and a stubbornly high Yen.  Specifically, Toyota is set to report a loss of US$3.8 billion for the latest fiscal year, its first loss since 1963.  Nissan will post a loss of US$2.8 billion.  While Honda is still projected to make a profit, it is set to post a profit that is down by more than 80% from last year.  Electronics maker, Sharp Corp., just announced a larger-than-expected loss of US$1.3 billion for the fiscal year ending March 2009.  Meanwhile, one of its main competitors, Sony, is projected to report a loss of US$1.1 billion for the fiscal year ending March 2009 as well.  In addition, Japan Airlines just signaled it might need to turn to the Development Bank of Japan for loans, as it struggles to refinance US$300 million due in August.  Finally, even though Japan has one of the healthiest banking sectors in the developed world, many of its financial institutions are now grappling with their own rising loan losses and falling fee income, in addition to their depressed equity holdings.  Specifically, Mizuho Financial Group, which has already raised US$4.4 billion of capital since December, is under pressure to raise more capital, as Moody's cut its credit ratings.

From a macro standpoint, the IMF expects Japan's GDP to contract by 5.8% in 2009, while the OECD expects it to decline 6.6% (revised from its 0.1% decline that it projected in November), driven by the unprecedented decline in exports (Japan's February exports declined by 50.4% on a year-over-year basis).  Meanwhile, Japan's government debt to GDP ratio is expected to rise to 197.3% by the end of this year, up from 172.1% (which is already much higher than the second most indebted country, Italy) in 2008.

That said, the relative strength of the Nikkei (note that there are no currency effects in this index) against the S&P 500 has been improving since late October of last year, as shown in the following chart courtesy of

Tokyo Nikkie Average (EOD) ($NIKK) Price Relative to $SPX

Note that the Nikkei has already closed above its 20-week exponential moving average in the last two weeks, while the S&P 500 is still trading below its 20-week exponential moving average.  Interestingly, on a relative basis with the Dow Jones World Index, the Nikkei actually carved out a bottom in early March of last year, with a higher low in mid October (as shown in the following chart courtesy of

Tokyo Nikkie Average (EOD) ($NIKK) Price Relative to $DJW

So why has the Japanese stock market been rebounding, and why has it been exhibiting relative strength, despite the worst earnings news and economic data emanating from the country in arguably 50 years?  The first argument is contrarian in nature.  Every institutional and retail investor around the world has already given up on Japan, including this author (which I discussed briefly in our February 1, 2009 commentary).  That is, the data and news flow has gotten so bad that it can't get any worse.  Indeed, the number of analysts' downward earnings revisions in Japan has started to slow down, while its February machinery orders surprised on the upside by posting a 1.4% gain from January, versus a market forecast of a 6.7% decline.

The second reason – as we discussed earlier – is driven by valuations.  For example, on both a price-to-book and an EV/Sales basis, the Japanese stock market has been the cheapest market for a while now (see following table courtesy of Goldman Sachs).  If Japanese companies are willing to go through painful (but necessary) structural reforms to make their companies more efficient, then they could easily raise their ROEs to the 10% to 15% level in a very short time.

On a P/B basis, the Japanese market is now at its cheapest level since this bear market started (and while not shown, the Japanese market is also at its cheapest level since the early 1980s):

Japan P/B

Still another reason is monetary/liquidity in nature, as the Bank of Japan just reported the highest year-over-year growth in its monetary base (at 6.9%) since May 2004, as shown in the following monthly chart (which shows its second derivative as well as the year-over-year change in the Nikkei):

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly)(January 1991 to March 2009) - While the y-o-y growth in the monetary base (6.9%) is now at its highest level since May 2004, the BOJ still has its work cut out for them, as the monetary base is still at near its below its April 2006 level. More needs to be done!

Note that the year-over-year rate of change in the Japanese monetary base and the Nikkei has been diverging since January 2008.  While the Bank of Japan definitely needs to pump up its monetary base in a more aggressive manner – even a year-over-year increase of 6.9% should be sufficient for a meaningful rally.

My sense is that the Japanese market – despite the horrible fundamentals and horrible demographics – is rallying because of the combination of the above three reasons.  Interestingly, while many Japanese companies have been resisting institutional reforms, they are now less reluctant to do so as it is now a matter of survival.  For example, all the major Japanese auto companies are now reducing headcount in the form of voluntary buyouts.  For the companies that continue to resist these reforms to streamline their operations, they will either ask the government for loans, or go bankrupt.  Since most (smaller) companies do not have access to government loans, they will most likely go bankrupt – which will pave the way for further Schumpeterian “creative destruction” in the Japanese economy and allow for outsized profits going forward.  With the Japanese government just announcing a larger-than-expected US$156 billion stimulus package (from an expected US$100 billion package), my sense is that the Japanese equity market will continue to exhibit relative strength going forward.  However – and this is important – I am still relatively bearish on many companies that depend on exports for the majority of the businesses, including the Japanese “Big 3” automakers and many of its electronic companies.  If one wants to purchase Japanese equities, I would instead recommend Japanese companies that depend on domestic consumption instead.  Non-Japanese subscribers would do this through various mutual funds or Japanese equity hedge funds.  For our US subscribers, various choices include the Matthews Japan Fund, the Fidelity Japan Smaller Companies Fund, and the JOF closed-end fund.

Signing off,

Henry To, CFA

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