Japan Equities May Look Attractive, but Look at U.S. Economy First

Over the last few months, it has been a popular trade among Asian hedge funds to short Japanese stocks and go long Hong Kong and China. It's been a very profitable trade for these funds, but its looking pretty crowded, so once it unwinds you could see some sharp moves on the upside for Japan. These hedge funds have been selling to accumulate cash ahead of their book-closings at the end of the year, and many analysts suggest that most of this selling has now run its course, meaning that the Nikkei may have reached a very significant bottom at current levels.

A recent article published in Barrons painted a rosy picture of Japanese valuations, with the magazine telling investors to buy "cheap" Japanese stocks. It is common knowledge that Japan is the cheapest on a price-to-book-value basis, and Japanese shares trade today at a price-earnings ratio similar to U.S. equities. Japanese earnings are growing somewhat faster than the U.S., but the main difference is that Japanese interest rates are sharply lower than U.S. rates. More significantly, many feel that the recent return to a more traditional Japanese government means that interest rates will continue to remain low for some time, which should benefit corporate Japan.

Jonathan Allum, an analyst at KBC Financial in London, said that the single measure with "an unblemished track record of spotting times to buy" Japanese stocks is about to start flashing green. Allum says the signal comes whenever the dividend yield on Japanese issues exceeds the yield on Japanese government bonds. Stocks now yield 1.46% - just under 1.48% on the relevant government bond. Some fund managers may claim that the Japanese market is cheap, but cheap markets do not always mean value.

When thinking about the negatives for Japanese stocks, deflation comes to mind first. Skeptics say that Japan has yet to emerge from deflation, as rising prices have been caused by commodity price inflation rather than an actual increase in consumer demand. Optimists point to residential property prices jumping higher while commercial real-estate prices and rents are edging up. Several analysts expect rising oil and food costs will feed into consumer prices. "As long as Japan continues to revert back to a more traditional style of government and outsources entry level manufacturing while holding down wage growth, deflation is likely to continue," said a blogger.

The other problem I have with investing in Japan: You just can't trust the data. Many say the suggestion of weak Japanese consumption is a statistical fluke. Analysts point out that the first group of retirements by Japanese baby boomers (equal to some 8.6% of the Japanese labor force) is distorting reported average wage numbers downward. Given the tight labor market conditions in Japan, the upside in wage inflation is not being reflected accurately in recent data. "Do not take Japanese statistics too seriously," said David Pilling in a recent FT column. "Unreliable survey data, a permanent-revolution approach to methodology and the curious statistical impact of deflation on real gross domestic product have wrought havoc with quarterly numbers."

Has the Japanese Yen got any significant upside left? "The latest round of the yen's appreciation, triggered by the capital shift away from U.S. assets, is likely to come to a halt at around 107 yen, given the fact that yen-carry trade positions have been almost fully unwound," said Minoru Shioiri at Mitsubishi UFJ. "But looking further ahead, the market has to price in the deterioration of the actual US economy, which has so far been firm thanks to relatively solid corporate and consumer spending. Once this process begins, we may have to brace for a test of the 100 yen level.

"It should also be noted that Japan's recent call for China to let the yuan rise could mean that Tokyo will have to tolerate potential yen gains. That's because Japanese credibility could take a knock if it calls for yuan appreciation but at the same time doesn't allow the Yen to gain strength. The key idea: Japan's recent comments on Yuan strength could be an indication that they do not intend to weaken their currency even if it appreciates. This has important implications for Japanese exporters if we had to see another round of risk aversion.

In summary, Japanese valuations may look attractive but I'd wait for more clarity on the U.S. economy's outlook before buying. We shouldn't be in the business of calling bottoms, especially in the current environment. Saying that, Japanese equities will look very attractive if the U.S. economy will stabilize.