Japanese Equity Valuations are Historically Low & Quantitative Easing Could Lead to Further Yen-Weakening vs. the U.S. Dollar
Co-authored by Christopher Gannatti, Research Analyst, WisdomTree
Expansionary Monetary Policy-Possibly a 2012 Japanese Equity Market Catalyst
On February 14, 2012, the Bank of Japan (BOJ) made a statement that it would target a 1% inflation rate. Compared to the last 20-years when powerful deflationary forces gripped the Japanese economy, a 1% inflation target is a large commitment. At its latest meeting on April 27th, the BOJ took further steps to easing monetary pressures by raising the maximum outstanding amount of financial assets it can purchase through its asset purchase program, specifically through an additional 10 trillion yen in Japanese Government Bonds, 200 billion yen exchange traded funds, and 100 billion yen in equity issued by real estate investment corporations.
While true that the majority of the program's capacity is directed at the purchase of government bonds, we think the BOJ's stated ability to purchase up to 1.6 trillion yen of exchange-traded funds makes a statement that it is willing to pursue unconventional means in its attempts to affect change with respect to the longstanding deflationary expectations that pervade Japan's economic landscape.
The BOJ actions always create a lot of noise and activity in the exchange rate of the yen compared to the U.S. dollar. However, amongst all the noise and inherent uncertainty that characterizes both the yen and Japanese economy, an important point is that Japanese equities appear to be relatively low compared to their own history. Within the conclusions that follow, it is important to inform investors that we are referencing index data and returns. As such, investors cannot invest directly in indexes, and the data that follows does not account for costs, fees, or expenses in its calculation which may adversely impact the data and returns.
The Valuation Case for Japan
As of December 31, 1970 and December 31, 1971, the trailing 12-month dividend yield of the MSCI Japan Index was actually higher than that of the S&P 500 Index. Over the long period that followed, specifically from December 31, 1970 to March 31, 2012, average annual returns for the MSCI Japan Index were nearly 10%. We think that this might surprise investors, in that during more recent time periods Japan has been associated with lackluster equity market performance and extremely low levels of economic growth.
The next time when the trailing 12-month dividend yield of the MSCI Japan Index surpassed that of the S&P 500 Index occurred during the 2010 calendar year. As of March 31, 2012, the MSCI Japan Index had a trailing 12-month dividend yield that was still higher than that of the S&P 500 Index.
More recently, Japanese equity markets have been characterized by a "post-bubble" period with low returns. As of December 31, 1989, close to the peak of the Japanese equity market bubble, the MSCI Japan Index recorded one of the lowest trailing 12-month dividend yields during its history (less than one-half of one percent). This value was certainly below that of the S&P 500 Index as of the same date. Average annual performance from December 31, 1989 to March 31, 2012 was -1.47%. We believe this is the type of equity market performance people tend to associate with Japan, and our point is to emphasize that this has not always been the case.
Beyond the Extreme Bubble Example
In judging the aforementioned statistics, we understand that few would be unfamiliar with the Japanese equity market bubble, the peak of which was experienced in December of 1989. While the summary numbers above are important, we recognize that the data encompasses one extreme example that shows the potential risks inherent to subsequent performance of the MSCI Japan Index after recording low trailing 12-month dividend yields.
It may be helpful to cut the longer time periods that were shown into more relevant chunks for further analysis. Importantly, trailing 12-month dividend yields do not dictate future returns with certainty, and the analysis that follows looks to indicate what types of 1-year returns have typically been associated with relatively high or relatively low trailing 12-month dividend yield values. Additionally, this is done through index data which does not account for costs, fees, or expenses that may adversely affect performance. Investors cannot invest in indexes.
Figure 1: Quartile Analysis of Calendar Year-End Trailing 12-Month Dividend Yields
click to enlarge
There are 41 full calendar years of available data for which trailing 12-month dividend yields may be calculated for the MSCI Japan Index. We broke those 41 values into quartiles, and Figure 1 indicates the average return over the next year after a particular trailing 12-month dividend yield was observed. Returns in figure 1 are denominated in local currency.
There was a stark difference between the average 1-year return following a trailing 12-month dividend yield within the highest quartile as compared to the average 1-year return following a value within the lowest quartile-specifically 26.76%.
The average performance after a trailing 12-month dividend yield in the highest quartile outpaced the average of all 41 calendar years by 14.30%.
While this analysis certainly cannot guarantee that performance will be strong after a high trailing month dividend yield, we feel that it does indicate a certain relationship between dividends as a valuation indicator and the subsequent local equity performance of the MSCI Japan Index. Our full analysis, along with data on all 41 available calendar years, is available by clicking here.
Japan's equity markets have been difficult, to say the least, ever since the bursting of the equity bubble about 20 years ago. While the behavior of the yen/U.S. dollar exchange rate and economic policy remain uncertain, the trailing 12-month dividend yields of the MSCI Japan Index indicate to us that Japanese equities may warrant further consideration. Japan's performance following periods when its dividend yield is as high as today was significantly better than periods when Japan's dividend yield was at the opposite low end of the spectrum. This tells us that if there was a valuation indicator telling you when a good time to own Japan, the current signals suggest now may be as good a time as any.
MSCI Japan Index: A subset of the MSCI EAFE Index which measures the performance of the Japanese equity market. Within this paper, the MSCI Japan Index has returns that are measured in U.S. dollars.
MSCI Japan Local Currency Index: A subset of the MSCI EAFE Index which measures the performance of the Japanese equity market. Within this paper, the MSCI Japan Local Currency Index has returns that are measured in yen.
S&P 500 Index: A market capitalization-weighted index of 500 stocks selected by the Standard & Poor's Index Committee designed to represent the performance of the leading industries in the U.S. economy.
MSCI EAFE Index: A market capitalization-weighted index composed of companies representative of the developed market structure of 21 developed countries in Europe, Australasia, and Japan.
Unless otherwise stated, data source is WisdomTree.
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments focusing on certain sectors and/or countries increase their vulnerability to any single economic or regulatory development. This may result in greater price volatility.
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Jeremy Schwartz and Chris Gannatti are registered representatives of ALPS Distributors, Inc.
 Deflationary-characterized by falling price levels.
 Bank of Japan.
 Trailing 12-month dividend yield: The sum of dividends generated over the prior 12-month period divided by the price per share. Higher values indicate that a dividend is accessible at a lower price which is viewed as favorable.
 Bloomberg, MSCI.
 Bloomberg, MSCI.
 Quartile: Segments a sample into four equal buckets, in this case four groups of 10 trailing 12-month dividend yields. Though there are 41 total years, the median trailing 12-month dividend yield is excluded.
 Local currency in the case of the MSCI Japan Index is the yen, so these returns would be in yen prior to any translation back into U.S. dollars.
Disclosure: I am long DFJ.