Japanese Stocks – Zen Perfection

Japan's stock market has been in the grip of a secular bear for so long, it appears a true capitulation has by now occurred – and if it hasn't, then it cannot be too far away. Consider the following data points, which we have recently come across in an extensive research report on Japan published by Asianomics (as an aside, any institutional investors with an interest in Asian markets should definitely take a look at what Asianomics has to offer. It is independent research at its finest. The link can be found in our blog roll).

Only between 6 to 8 percent of the daily trading volume in the component stocks of the TOPIX is accounted for by Japanese institutions (they are all busy trading JGB's instead it seems), another 20 percent are accounted for by retail traders (down from a high of 69%) and the remainder of trading – between 60 to 70 percent – is done by foreigners.


Even though foreign participation has become so high, there are today only a handful of funds left that are dedicated to Japanese equities and have assets of more than $100m.

However, Japanese stocks are cheap – they are the cheapest in all of Asia, and their valuation today is a far cry from that pertaining at the height of the bubble in the late 1980's. From an average price-to-book value of 5.4 and a P/E ratio of 80, they have de-rated to 0.9 times book and a P/E of 12.4

Moreover, the yield on Japanese shares has steadily risen in recent years and has begun to exceed the JGB yield by a healthy margin. Let's also keep in mind here that Japan's money supply growth is the by far lowest among the industrialized nations, so one gets paid this yield in what is currently undoubtedly the best confetti money in the world.





TOPIX vs. JGB yield, via CLSA – click for better resolution.



It must also be borne in mind that Japanese companies have an incentive to under-report their earnings in order to keep their tax payments low, which they do by means of accelerated depreciation. Their operating cash flows amount to 177% of reported profits, the by far highest in Asia and almost three times those reported by Asia's operating cash flow poorest market, China. In other words, if one were to assume a run-of-the-mill depreciation schedule, then P/E ratios would be in the single digits.

Debt-to-equity of non-bank companies has fallen to 35% from a previous high of more than 100%, and Japanese companies are sitting on ever bigger pile of cash (indeed, in the small cap universe there are a number of companies that have  cash hoards exceeding their entire market cap).

Having said all that, the Nikkei looks technically like the equivalent of a wasteland. As stock markets go, it has over the past few years become a master at the technique of 'going absolutely nowhere in the most unexciting fashion imaginable'. That is very Zen of it, but it presumably drives many long only investors in Japanese stocks up the wall. One really needs the patience of a Roshi to invest in this market.



The post bubble Nikkei, monthly chart. Since the 2008 crash, this market has fallen completely asleep – click for better resolution.




To invest in Japanese stocks, you must become like him …

(Photo via Wikimedia Commons)




A continuous daily chart of the nearby Nikkei futures contract shows how this market has lately bored everyone to death – click for better resolution.



 Nikkei traders can alternatively help themselves by chanting Buddhist mantras.




Of course, there is something to liven things up a bit for foreign investors and that is the yen. In dollar terms the Nikkei has performed far better in recent years.




The Yen

The fact that foreign investors are the nowadays accounting for most of the trading volume in Japanese stocks has a drawback: a strong belief has taken hold that these stocks cannot rise unless the yen falls. However, as noted above, Japanese money supply growth has been and continues to be extremely low – hence the yen's strength.


A long term chart of year-on-year growth in Japan's M2 + CDs (via speculative-investor.com).Money supply growth was brisk during the bubble era, but has been very subdued in the subsequent deleveraging period – click for better resolution.



Actually, this belief may be misplaced. For one thing, Japan's exporters have handled the strong yen quite well. Secondly, everybody in Japan except the exporters of course profits from the strong currency. And even the exporters have input costs to think about. After all, Japan imports most of the raw materials it needs.

Naturally though the question arises if the yen will remain strong. From a fundamental perspective this cannot be answered definitively yet, as it will depend on how far the recent challenges to the BoJ's independence will go, which in turn will depend on who wins the upcoming election. If it were up to the BoJ itself, i.e., if it were not under such great political pressure, we would expect money supply growth to continue to putter along at a low rates. As we have pointed out before, the BoJ's policy is informed by the institutional memory of the post war hyperinflation and by Japan's demographic situation. In the population of Japan, there really is no constituency for inflation and a weak currency – only overeager politicians pine for more inflation.

Given that Japan's current account and trade surplus are currently under threat, a looser BoJ could eventually bring about a weaker yen. We will discuss  the nature of the political threat to the BoJ's independence in more detail in part two.

Due to its ongoing 'QE' operations, the BoJ's assets have grown back to the level of 2005. In early 2006, the BoJ actually attempted a 'QE' exit, and this sudden decline in Japan's monetary base may well have delivered the coup de grace to the US housing bubble (the bubble was however already endangered due to a sharp slowdown in US and euro area money supply growth at the time). In 2006, the yen was still widely used as  a funding currency, a trade that has blown up with the 'GFC' in 2008.


The BoJ's assets over the past decade – back at the level of 2005 – click for better resolution.



Japan's trade balance has turned negative. This has partly to do with the decision to give up nuclear power generation after the Fukujima accident – Japan must now import more fossil fuel. The recent spat with China meanwhile has pressured exports in the short term – click for better resolution.



The current account balance is still propped up due to Japan's large foreign investment income, but it is obviously no longer what it once was (the most recent reading was actually negative and is not yet depicted on this chart) – click for better resolution.





One of our readers (P.N.) has graciously provided us with both short and long term Elliott wave counts of the yen, which we hereby present as long as they are still fresh. These suggest that there may be some additional weakness in the near term, followed by a bigger up-down sequence and then more strength to complete the long term uptrend in the yen. Thereafter a primary trend change should occur (it should be noted here that this could come about due a strengthening dollar, it doesn't necessarily have to be due to general yen weakness).



The daily wave count of the yen, courtesy of P.N. – currently speculators are very much short yen futures, so any additional near term weakness is likely to be temporary, precisely as the projection derived from this wave count indicates. Note that this chart depicts the inverse of the rate that is commonly used, so 'up' means a stronger yen here – click for better resolution.



The yen wave count, weekly, with a longer term projection. Note that the projection is meant to indicate direction rather than extent of the moves – click for better resolution.



The monthly yen wave count shows it to be in wave [5] of the long term trend that began in in the early 1970's. The coming few years should be volatile, but ultimately resolve in another move to new highs, before a bigger trend change begins. Note that this wave count starts out with the subdivisions of wave [3], wave [1] is depicted in the next chart – click for better resolution.



An even longer term chart in the normal yen-dollar notation (down means a stronger yen). Here we can see the very beginning of the yen's long term uptrend in the early 1970's – click for better resolution.



The big question is of course if the Nikkei will continue to be driven by the yen over the next few years. If we were to guess, we would say yes in the short to medium term, but it will probably diverge from the yen once the currency embarks on its final rally and reaches its projected long term peak. This is of course provided that this wave count and its projections turn out to be correct,  but to our eye it seems to make sense and is also in keeping with our fundamental expectations. More on those follows in the next Japan update.

Charts by: stockcharts, bigcharts, bloomberg, tradingeconomics, speculative investor, finviz, PN, St. Louis Fed, CLSA


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One Response to “Reconsidering Japan, Part One”

  • roger:

    Hi Pater,

    There seems to be a completely opposite view regarding Japanese companies (particularly the exporters) from Hugh Hendry as described in his April letter:

    He discussed Japanese companies in depth in pages 7-10. Basically he postulates that as Japanese are exporters to China and China is experiencing significant slowdown, the exporters are going to get hurt badly. He draws some comparisons to the Great Depression era, when the UK was primarily the importing country & the US was the exporter, in which the US experienced much sharper contraction.

    Besides the comparison, he cited some interesting statistics on the companies he probably purchased their CDS’s.

    How do you consider his point of view regarding the Japanese companies? Using the data you outlined, it will make a lot of sense for the Japanese companies to sport very low risk premiums on the CDS. But from Hendry’s point of view, those CDS’s are very likely to blow up soon.

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