Japan: Where Sentiment Went To Die

Includes: FXY
by: Acting Man

Just Say No to Risk

Back when the technology bubble in the U.S. peaked, one question that suggested itself was whether there would ever be a mirror image to the extreme in positive sentiment recorded at the time. For instance, at the end of February 2000, a full 92% of all Rydex fund assets were in bullish funds, there were record inflows into mutual funds dwarfing anything seen before and the mutual fund cash-to-assets ratio went to what was then a record low of 4.4% (although actually higher than today's ratio, one must keep in mind that this happened with the Federal Funds rate at 6%, so cash was more than just yield-less trash).

Anyway, it appears we have found the mirror image – the maximum pessimism that reigns at the tail end of a grueling, over two decades long bear market that without a doubt marks one of the biggest extremes in negativity ever recorded in a post-war industrialized society. We are of course referring to Japan, where "caution" has become the watch word.

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"Caution" in Japanese (these two characters: 注意)

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Here we go again (this one can be found in train stations and warns of bag snatchers – in spite of the fact that there actually barely exist any bag snatchers in Japan; but you never know, right?)

Some of the data on how risk-averse Japan's citizens have become are truly astonishing. We have already commented on the large decline in participation in the stock market, which has increasingly become a place where only foreigners still play. However, there is more.

Bloomberg reports:

“The stock market isn't the only place where the Japanese don't like to take chances. The country suffers from a play-it-safe mentality that's become ever-present in daily life, according to Harvard University sociologist Mary Brinton. “There's a tendency to focus more on potential downsides rather than on opportunities,” says Brinton, co-author of “A Japan That Turns Its Back on Risk”, a book published in 2010. That may explain why regulators held up vaccines approved decades earlier in other countries, why few Japanese students choose to study abroad, and why 844 trillion yen, almost twice the country's yearly economic output, sits idle in cash at home and in savings accounts earning 0.02 percent.

Even in the sporting world, Japanese tend to avoid risk: Rather than swing for the fences, professional baseball teams in Japan bunt twice as often as Major League Baseball teams in North America, sacrificing a runner in order to increase the chances of a safe score, according to a 2005 study by Ken Oikawa, a professor of kinesiology at Tokyo Gakugei University.

About 73 percent of Japanese describe themselves as risk-averse, according to a 2008 study of 51 countries by Stockholm-based World Values Survey. Ghana, Indonesia, and India had the highest rate of respondents who said taking risks is important. According to the Global Entrepreneurship Monitor, fewer than 4 percent of working-age Japanese intend to start a business within three years. That's the third-lowest rate among 54 countries surveyed last year, behind only the United Arab Emirates and Russia (the U.S. is 19th). Although Japan's population of 127 million is less than half that of the U.S., Japanese spend nearly as much as Americans on life insurance: Total expenditure on policies in Japan last year was $525 billion, second only to the U.S. at $538 billion, according to a study by Swiss Re.

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Japan's Nikkei Index since the 1989 bubble peak – the mirror of a declining social mood.

As one of the many risk-averse Japanese citizens relates regarding his feelings about the stock market:

“My parents taught me: ‘Don't gamble and stay out of the stock market,’ ” says Toshiya Enomoto, an engineer who keeps his money in a bank account. “The whole business seems unsavory.”

That is of course what such a long bear market will eventually do. Very few in Japan think about the fact that it is one of the cheapest markets in the world today and may represent an opportunity. All they see is risk.

And yet, it would be quite erroneous to state that this extreme caution is somehow an innate Japanese trait: after all, the Nikkei once traded at nearly 39,000 points with its trailing p/e ratio sitting at well over 80 at the time. Obviously there was therefore a time when instead of caution, extreme risk taking was quite fashionable. We remember that time well. In the late 1980s, there was a pervasive conviction that Japan and its state-directed mercantilist business model were invincible. Its market capitalization amounted to 45% of global market cap at the time and it was widely held that Japan would "take over the world". Critics that pointed the market's egregious overvaluation out were advised that "Japan is different". All sorts of rationales were forwarded to justify the lofty valuations. Incidentally, some of the very same arguments were later employed to explain the persistence of the bear market, such as e.g. the pervasiveness of the keiretsu cross-shareholdings system. Instead of representing a guarantee that stocks would never fall, it became a perpetual "overhang" bedeviling the market.

It's even intruding into pop music: "Caution", by Shigeru Suzuki

Just to be safe, wear a face mask when you go to the stock exchange …

Will Things Ever Change?

The big question is of course whether this extreme in negative sentiment will ever reverse. Just as there were a thousand reasons why Japanese stocks would never fall in the late 1980's, there are a thousand reasons why they will never again rise forwarded today. The problem for contrarians is the persistence of the negativity, that is by now defying belief. After all, just as many people have tried in vain to make money shorting the JGB market and the yen over the decades, so is the landscape littered with investors seeing their "bargains" in the Japanese stock market going nowhere in increasingly uninteresting ways for a long time.

We must confess we have no answer either. When Japan's market began to rally in 2003, it initially looked like the most promising rebound since the beginning of the bear market. At its 2007 high, the rally had adopted an impulsive shape and by contrast to previous advances it didn't have the hurried look often attending bear market advances. Rather, it was a fairly slow, methodical advance. And yet, the market once again fell to new lows subsequently as the GFC unfolded. From a purely technical perspective the sideways move in the Nikkei since the 2009 low doesn't look particularly encouraging either. It cannot be ruled out that even lower nominal lows will eventually be seen (balanced by a strong yen from the point of view of foreign investors), but we will have to wait and see about that.

Naturally, Japan's demographic situation, the pervasive conservatism and the well known fiscal debt problem all seem to loom large against a revival. Today more diapers for adults are sold in Japan than diapers for babies. Isn't the situation hopeless? However, one would do well to remember at this juncture that this is precisely the situation found near major lows – all the fundamentals look bad and well beyond remedy, with a sole exception: stocks are cheap.

A Merrill Lynch survey conducted in November found that the net exposure of global fund managers to Japan is at a one decade low.

As one manager who invests in Japan puts it (James Hunt of the Toqueville Global Value Fund):

“One of the questions we are asked most often by investors is why we would invest in Japan. Normally, there is a slight tone of derision in the question, as if to say: ‘Everyone knows that Japan has poor demographics, a huge public debt and weak growth prospects.’ And of course, all of these things are true.”

Hunt says his case for Japan boils down to its deeply contrarian pull: “Everyone thinks Japan is sinking into obscurity,” he writes, “and this negative sentiment provides us with the opportunity to buy what we consider to be excellent global franchise businesses at attractive valuations.”

Noting that Japanese equities have lagged their U.S. counterparts by 25 percent over the last two years, Hunt writes, “The storm of negative factors affecting Japan combined with the poor market performance is just of the sort of situation that piques our interest.”

Over the last 12 years of economic stagnation, Japan's Nikkei 225 Index has, in dollar terms, posted zero total return. Meanwhile, aggregate earnings for its profitable companies have gone from ¥438 billion ($5.3 billion) to ¥608 billion, while their return on equity has swelled from around 6 percent to nearly 10 percent. At the same time, notes Hunt, the price-to-earnings ratio for these profitable listings has collapsed from 24 to 15, while their dividend yield has tripled to 2.3 percent.

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A brave soul. Perhaps one will now have to wait for Mr. Hunt to throw the towel as well, but he does have a point. As bad as things appear to be, this is largely reflected in prices. And the negativity is not only pervasive, it has also been with us for a very long time. Consider in this context the remaining assets in the Rydex large cap Japan fund, which are down by over 90% from the 2007 peak:

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There's no love for Japan among Rydex traders either; the large cap Japan fund has seen its assets dwindle to a paltry remnant (chart via sentimentrader).

The big question is actually not so much whether things will change, but when they will. This remains unknowable, but we are struck by how extreme the negativity has become. Unless everything we know about contrarian opportunities needs to be rewritten for Japan, it has to eventually mean something.

As it were though, one can unfortunately not even rely on Godzilla anymore.

The presence of Godzilla does not obviate the need for separate Zombie infestation defense measures.

Addendum: Demographics

Meanwhile, the demographic problem is inviting solutions that should perhaps not be entirely unexpected: over 5.7 million people in Japan today are working beyond the age of 65. As one such working pensioner says:

“The pension isn't enough to live comfortably,” says Kazuyoshi Hirota, 69, who works 24 hours a week as an apartment building manager and janitor in central Tokyo. Hirota retired seven years ago from his full-time security job at Asahi Group Holdings. His wife, 70, works as a cleaner. It's not just about the money, though: “Life is boring without work,” he says.

Charts by: Sentimentrader, BigCharts