Japanese Value Stocks: Excess Liquidity and Extreme Volatility

The global sell-off continues in Asia, with the Nikkei 225 losing 3.34% on March 5, the Shanghai SE B and Shenzen SE B indices falling over 6%, and most other markets in the region also losing +/- 3%.

The Yen climbed to JPY115.37 against the US dollar and to JPY151.77 against the Euro on more signs of yen carry trade unwinding. Adding fuel to the fire Japan time was:

Strong growth (+16.8% YoY in Q4) in Japanese capital expenditures,

Comments by the People's Bank of China governor Zhou Xiaochuan who hinted that China is contemplating letting the Yuan trade in a wider range added fuel to the fire, and

Evidence that Japanese investors (who account for a large percentage of the yen carry trade) are repatriating funds.

Regular readers will remember that we cautioned in our January 1, 2007 newsletter (Pops and Flops in 2007) that 2007 could be a volatile year, given the late stage of the economic expansion, still-loose monetary policy and the sheer amount of liquidity sloshing around in global markets. Typical signs of excess liquidity include recurring bubbles, generally high risk tolerance, and periodic bouts of high volatility, such as we are now seeing.

Many market commentators are ignoring history in expressing surprise that China could be the ostensible source of a global sell-off, or even global contagion. In fact, emerging markets are often the source, as was seen in the Latin debt crisis (Mexico) in 1982, the Asian financial crisis (Thailand) in 1997, and the Russian default in 1998.

On the other hand, we believe investors are overly fixated on the yen carry trade, which, while a source of volatility, is but one source of excess liquidity, along with rapidly rising savings in Europe and Asia as well as substantial surpluses in oil producing nations.

Given still abundant liquidity, investor reaction to the deliberate attempt by the Chinese government to cool excessive speculation and the renewed "growth scare" regarding the US economy are but temporary impediments to a resumption of the bull market.

In terms of short-term tactics, we would avoid Japanese companies with high yen exposure (particularly those with weak fundamentals like Hitachi (HIT) and NEC (NIPNY)) because of yen carry trade concerns, smaller capital companies, and companies with traditionally high market betas (Nomura Holdings (NMR)).

On the other hand, we would be increasing positions in the "Dogs of the Nikkei" (i.e., high yield stocks aka the Dogs of the Dow strategy) and REIT stocks, as TJI's Dogs of the Nikkei and REIT model portfolios continue to record average YTD performance of over 11% and 16% respectively. In other words, value stocks are as attractive as ever.

Disclosure: The author is long EWJ.

Comments

[Lance]

Nice call on Nomura. It has bounced nearly 10 percent since you said to avoid it.

[DarrelWhiten]

Dear Lance;

Yes, after the stock tanked from JPY2,870 to JPY2,310 (19.5%), and the ADR is down some 4% since (from your March 9 call), so your Nomura trade is now up only 6%. From where do you want to start measuring whether yours is longer than mine?