The Long Case for Japanese Stocks (EWJ)

The Nikkei 225 Stock Average rallied 3.4% overnight for its second largest gain of the year and is now back over 15,000. If the market holds on or adds to the gains tomorrow then it looks as if the Nikkei may have bottomed out on June 13th at 14,218. As economic data clearly validates the strength of the economy, Japanese stocks look ready for a second-half rally.

All eyes continue to be on the Bank of Japan and Fed but I wonder if the inevitable quarter-point rate hikes expected sometime during the summer in Japan and next week in the U.S. aren’t fully priced into stocks.

The 225 stocks that make up the Nikkei currently trade at 19.12 times trailing earnings and 18.56 times forward earnings. The forward figure should be lower due to conservative estimates but means there is less chance of a negative surprise and naturally more chance of upside out-performance.

Blue chip stocks have cleaned up their balance sheets and are putting cash to work in share buybacks and increasing dividends. Adding shareholder value is top priority and that means limited downside for investors. The current average yield of the Nikkei 225 is 1.03% on a trailing basis and 1.12% on a forward basis. Expect those figures to increase even as share prices rise. M&A activity is expected to remain strong and a new law effective next spring will allow foreign firms to use their shares in acquisitions. This will keep management focused on increasing shareholder value.

CAPEX has surged in recent months in Japan in anticipation of an end to the zero-interest-rate-policy (known as ZIRP). Thus, despite a drop in corporate sentiment due to the correction in the stock market, the economic climate remains favorable for growth.

A quarter-point rate hike is healthy for the overall Japanese economy as it attempts to “normalize” its monetary policy. The Koizumi Cabinet is starting to warm to the idea even though it will put pressure on the national deficit (see related WSJ article, paid sub required). Two quarter-point rate hikes by the end of the year shouldn’t hurt growth or be damaging given the near-zero rate at present. Japanese banks are certainly ready.

The BoJ has reportedly already drained excess liquidity from the money supply which has continually prompted fear over the end of the yen carry trade. A WSJ article from today cites Morgan Stanley's (MS) head of currency research, Stephen Jen, who said, "Every hedge-fund investor assures me that these carry trades are massive, but I am yet to find one hedge-fund investor who himself runs such a position." After all, wasn't it the BoJ's clamp on liquidity in addition to global rate hike fears that sparked the recent global sell-off?

The yen is expected to strengthen against the dollar again from the second half of this year, especially once the BoJ initiates a rate hike. Yesterday the Financial Times on-line published an excellent article discussing the yen. For foreign investors (particularly American investors) in Japanese equities I see a strong yen as downside protection and/or an upside boost since a stronger yen represents a gain for yen-denominated investments bought using dollars. The headlines always read how Japan is fearful of a strong yen but I don't see too much negative there given overseas expansion and acquisitions where a stronger yen is beneficial. Not to mention that imports will be cheaper.

I am confident buy interest in Japanese equities will return and help fuel a second-half rally and an uptrend through 2007. A slowdown in the U.S. economy and equities is more psychologically damaging for Japanese stocks than anything else. Japanese manufacturers such as in autos and consumer electronics tend to be much more efficient and have much higher margins than foreign competitors. That means they can remain profitable even if sales volume declines.

Helping buy interest already are foreign private equity firms and new investment funds specializing in Japan. Japanese retail investors will have a hard time not buying up domestic stocks given the aggressive expansion of brokers and asset managers pursuing a growing labor force, rising salaries, and retiree savings locked up in near 0% interest savings accounts. Don't forget that compared to emerging markets, Japan has the second largest capitalization of securities in the world.

Domestic demand stocks are preferable to export-driven stocks but a well-balanced portfolio of Japanese stocks at low transaction costs and high liquidity should suit most investors. iShares MSCI Japan Index ETF (EWJ) continues to be the best option in my opinion for these reasons (diversification, low expenses and high trading volume).

iShares MSCI Japan Index 1-year chart:

Comments

[Enzio von ...:]

Steven, next to your salient points, a rather obvious one. The reason that any Central Bank raises rates is precisely because growth is good - i.e. because profits are rising. That is why markets often tend to do o k while Central Bank rates are rising - and then plunge once the Bank stops raising rates. The logic of our Economic Clock at this juncture of a rate peak is simple: now the Central Bank expects an "excess supply of goods" to emerge, so down go profits expectatins and hence markets.

2006 Jun 23 05:38 AM

[pascal jean...:]

good point from Enzio . This said the BOJ tightening has been already largely priced in the market and I am not overly concerned by Japan considering the ample domestic liquidity for onshore equities investments. Same goes for earnings and Japan can certainly accomodate a mild US slowdown.
However the point is now rather : will FOMC tighten further in august (probabilities are as high as 70 %) In which case at what stage will the typical scenarios of stagflation or economic slowdown take the lead amidst US financial community ? In a certain way news of a US house price fall or economic slowdown would be welcomed at that point by Japanese stockmarket.

2006 Jun 23 01:30 PM

[Enzio von ...:]

Hi Pascal,
Fully agreed. Who can guess what the US financial community will think if more FOMC tightening occurs? I've been suggesting Fed Funds of around 6% this year, so that would suggst slowdwn in America. For me, the further question is: must this unequivocally have a knock-on effect in Japan and thus its market, if Japanese growth is driven increasingly by domestic demand as opposed to exports. If my "domestic demand" story is right, then Japan has to be a screaming buy, courtesy of an ever-improving Economic Time....

2006 Jun 28 02:59 AM

[Internet2k4:]

As an EWJ holder I've been perplexed lately by the strengthening of the Yen versus the U$. I certainly agree that if the domestic demand tend is solid buy Japan, but I read current account surplus as dependency on and vulnerability to US economic momentum and am not very confident that the Japan spike has been based on domestic as opposed to US demand. Any further data or thought on this appreciated.

2006 Jun 28 08:46 PM

[Enzio von ...:]

Who knows? I would not put too much emphasis on US demand dictating Japan's current account surpluses. Seems to me like China is playing an increasing role via cheaper japanese imports from China and thus more Japanese exports to America, once the China-made product has had a final once over in Japan.
Get a good stock person to tell you what is mainly responsible for Japan's stock market performance. My guess, as a macro guy, is mainly the domestic plays.

2006 Jun 29 02:33 AM