The financial press, most notably a recent cover story in Barron’s, has been screaming that investors should buy Japanese stocks. Sure enough, money has been moving that way, with large inflows into the Japan ETFs: EWJ, ITF, JPP, DXJ, JSC and EZJ.
At least some of the money seems to be coming from investors selling emerging market ETFs (EEM, VWO), which have seen large outflows. I think this is a case of dumb money flowing the wrong way following simplistic analysis and momentum.
The few who acted immediately may have made a nice short-term profit, but they will likely be disappointed soon. Those acting this week will find their buy disappointing in the future. There are many other parts of the world where their money will see better returns.
The currency, at the current exchange rate of around 80, is unsustainable for Japanese exports. The BOJ and the G-7 have already intervened to prevent more strengthening. A weaker yen pulls down the ETFs which are priced in dollar terms.
The Exchange Rate – Expect a Weakening Yen
A great deal of the move in Japanese ETFs has been due to the rapid appreciation of the yen up to record postwar levels. The recent G-7 intervention lifted the yen from those lows, but it still remains quite strong.
A strong yen is terrible for the export oriented Japanese economy. Japanese authorities have pursued a weak yen policy for decades in order to keep the country’s exports competitive. As one example, Japanese autos will need to raise prices to remain profitable just at the moment U.S. manufacturers have improved quality.
Reconstruction will be more expensive due to more expensive commodities, which are priced in dollars. It’s likely that many non-Japanese companies will choose not to rebuild destroyed facilities in Japan and will instead move them elsewhere in Asia.
Other costs for foreign companies will be more expensive, leading them to relocate non-essential operations elsewhere in Asia. Japanese consumers will face higher prices adding another hit to consumer spending.
Currency volatility is likely to continue to add to the risks for investors and those with commercial interests in Japan. Consumers and Japanese firms will find uncertainty in their planning for purchases or imported goods.
If you want to play the yen on the downside for a short-term trade, consider the double short Yen ETF (NYSEARCA:YCS).
Prospects for the Japanese Economy and Stock Market
The Japanese stock market has been pretty much dead money for years, certainly compared to other markets around the world. The current tragedy is only likely to add to Japanese economic woes. It is hard for me to understand how a tragedy that wipes out 3 -5% of the Japanese economy makes investing in Japan more attractive. The Japanese market is only at levels seen in late November of last year. The Japanese stock market lagged in the recovery of global markets since then, so why would it perform well going forward?
The Valuation Argument
I don’t buy the argument that the Japanse stock market is cheap at a level 10% below the recent highs -- a price equal to that of last November. The bullish analysts point to the low P/E for Japanese stocks and low price-to-book value relative to other world markets. But that has been the case for years. Why would an economic tragedy and a moderate decline in the Japanese market relative to the long term make the market more attractive?
For instance, these analysts argue that the Japanese market is trading below book value. I find that argument incredibly simplistic. With all the horrible destruction, obliterated factories, future bankruptcies leading to bad loans, and claims on insurance companies, surely there has been a hit to assets and thus book value of Japanese companies? The same is doubtless the case for future earnings. If the Japanese market is trading at the P/E and P/B of last November, how could it possibly be cheap now?
Certainly on a risk adjusted basis it is hard to see the Japanese stock market, particularly in dollar terms, as attractive.
How Many Companies Will Choose Not to Rebuild in Japan?
Many articles have pointed out how sensitive many industries have proven to be to interruptions in their supply chain. Dependence on a single part that could be sourced only in Japan has stalled both high and low tech manufacturing around the world.
It is almost a certainty that many of the destroyed manufacturing facilities in Japan will never be rebuilt there. Corporations have doubtlessly learned their lesson and will geographically spread their production going forward, especially with Japan's relatively high labor costs and the strong yen. Furthermore, the shape of the world's economy has doubtless changed since many of those factories were built, with better trained and cheaper labor now available elsewhere in Asia.
The difficulties in running manufacturing facilities will increase, certainly in the devastated areas. The ports are damaged. Some of the labor force will likely not return. The reliability of the electricity supply will likely be uncertain for quite a long time. Japan currently gets 1/3 of its electricity from nuclear. The decision to build those despite the risk of earthquake damage was based on confidence in Japanese skill in earthquake-proofing. Clearly that faith has been shaken. A shift to other sources will necessitate rebuilding costs and also increase dependence on imported oil and other commodities.
The Known Unknown
The tragedy could get much worse. Already the death toll is far worse than intial reports. The food supply will be damaged, requiring more imports for a country that already imports half its food, and areas could become permanently uninhabitable and/or unfit for agriculture The hit to the Japanese GDP could be far greater than currently estimated.
Conclusion #1: Don’t Buy Japan
It is difficult to see how increasing an allocation to Japan in a global portfolio will turn out to be a wise decision compared to opportunities elsewhere in the world. Looking at the risks described above, even if one argues Japan is a buy from a price/valuation point of view, is it really a good buy on a risk/reward basis?
Conclusion #2: Do Buy Other Oversold Markets
During crises like these, it seems to me the smart move is to look around the world for which markets have sold off in sympathy with relatively little justification. I pointed out last week that the German market fell as much as 10% and represented a buying opportunity. The German ETF (NYSEARCA:EWG) is already off its lows.
I also expect Asia ex-Japan to be a long-term beneficiary of the relocation of economic activity away from Japan. And emerging markets often face sell-offs that represent panic and momentum (dumb money), presenting opportunities to less emotional investors. The India ETF (NYSEARCA:INP) sold off close to 20% late last year. Broad emerging markets (EEM and VWO) are lower as well.
I would certainly rather take the other side of the dumb money, which is currently selling emerging markets and buying Japan.
Those still looking to buy Japanese equities should look at DXJ, the WisdomTree Japan Hedged Equity ETF, which hedges out the currency exposure.
EWG (Germany), S&P 500 and EWJ (Japan): Click to enlarge:
Click to enlarge
Disclosure: I am long GMF. Clients of mine are long EWG, VWO and GMF