Building A Better Value Trap

Includes: CS, DB, EEM, EWJ
by: Kevin Wilson


Certain foreign markets look very cheap (e.g., EWJ, VGK, EEM) and might make good value plays, assuming that there's a catalyst and no systemic risk.

Take Japan as an example: Its markets are down 60% from the 1989 peak, corporations are flush with cash, and the BOJ is supporting the markets; yet I hesitate to commit a significant allocation to Japanese stocks.

Indeed, while corporate data may look promising in some foreign markets, their respective governments are doing their best on a national scale to "build a better value trap".

As a result of these government driven sources of downside risk, only the longest-term investor, blessed with a strong stomach, should be putting major allocations in foreign markets.

With all the carnage in global markets lately, many are looking for bargains, especially in seemingly cheap foreign markets like Japan. However, as pointed out recently by John Authers in the Financial Times, whenever Japan has seemed cheap at different times over the last 25 years, it has turned out to be, and remains, the "world's biggest value trap." Japan again looks cheap on a CAPE basis (25 vs. long-term average of 38) according to data from Research Affiliates, and of course, it is still down 60% or so from its peak in 1989.

Most TOPIX sectors are trading lower than their 15-year averages. A Japanese market ETF (NYSEARCA:EWJ) has already fallen 20% since its most recent peak in April of 2015. But a renewed sell-off has taken the market at least 3% below its August lows in spite of massive ($655 billion/year) QQE from the BOJ, and the newly announced plan to move portions of the banking system to negative rates (a "negative interest rate policy," or "NIRP").

Since this decision to move to NIRP, the 10-year JGB has gone negative on yield, and equity markets are reacting with fear and loathing. There is apparently a feeling amongst market players that Abenomics has stopped working, if it ever did. Exports are still falling despite a much lower yen over the last three years, and the government still plans to raise taxes next year, regardless of the calamity that followed the last tax increase (i.e., lower consumption) about three years ago.

Japanese companies have retained plenty of cash on their balance sheets, about $956 billion altogether, and an increase in both share buybacks and dividends would therefore seem logical. Indeed, the trend is already upwards for both. Profits have doubled over the last 20 years to about 3.5% of GDP. The problem is that Japan is highly cyclical, and yet another down cycle has begun.

Also, as John Authers reminds us, value investing requires a catalyst, and improving corporate governance may serve as one. Still, as much as I like the idea of buying such a cheap market that has also made big improvements in corporate balance sheets, I am hesitating on committing more than a token allocation to Japanese stocks. My reasons are as follows:

1) The Japanese economy is weak and may be entering a recession, 2) the Japanese government's plan ("Abenomics") has failed to stimulate economic activity in spite of a massive intervention in the markets, 3) the promised reforms representing the "Third Arrow" of Abenomics have never come to pass, 4) the huge government debt overhang in Japan, some 225% of GDP, is not really being dealt with, as the deficit increased by about $850 billion in 2015, 5) raising taxes will further limit growth, especially in the consumption-related sectors, but the increase is so small relative to the total debt that it has no chance of reversing the upward trend in cumulative debt, 6) the BOJ is already monetizing about 77% of the deficit, which is a de facto devaluation that will have a cumulative effect over time, and 7) demographic challenges are a major headwind to improving economic growth over time.

As I have stated elsewhere, "It is not clear how Abenomics can really address the demographic problem for growth. Just as we have seen in global central bank monetary policy failures, efforts to stoke demand artificially have not worked in most countries." So what are the Japanese to do? It would seem based on empirical analysis that since monetary policy in this situation has been manifestly ineffective, we must look elsewhere for permanent solutions.

It may be that the problem is demand-driven, but any lasting solution will likely be a supply-side approach. The notion that Japan's government would be willing to abandon its failed Keynesian and monetarist policies and adopt a supply-side answer is so unlikely as to be laughable. Instead, ever greater recklessness by the BOJ is the order of the day, and that creates a level of uncertainty that makes me squeamish about putting big money to work in the Japanese stock market.

Negative rates are going to go much lower over time, with unknown side effects. Any argument for stocks under these conditions is a de facto "TINA" ("There Is No Alternative") argument, which may be fine for a while, but on a risk basis will be highly speculative. In my opinion, in spite of all the good things going on in the Japanese corporate sector, the government seems bound and determined to build a better value trap.

Let's think about where else we could allocate capital right now, assuming the U.S. market remains dangerously expensive, as I have discussed previously. Many analysts have pointed to relative value plays in Europe (see ETFs : VGK, SCZ). The problem in Europe is that however cheap stocks may seem, the current banking crisis is capable of driving them down to much cheaper levels in the near term. The Italians alone have over $216 billion in non-performing loans.

Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS) have seen the lowest prices since the late 1990s this week. Bank bond prices throughout Europe are falling, in some cases by large amounts. NIRP has not stopped this trend, but it may end up shrinking the profitability of European banks even further. If the dollar falls, as some analysts like Jeffrey Gundlach expect, that will put even more pressure on European companies and markets. Debt burdens throughout Europe are very large, and in some places dangerously so.

The ECB promises ever more intervention of the type that hasn't worked yet. For example, as I've previously written, "…negative rates have prevailed in parts of Europe for almost three years, and there are now over $2 trillion of bonds in Europe with negative interest rates. Demand is not exactly cooperating though, at least so far." NIRP also has not prevented sharply declining manufacturing activity in the EU, including in the countries with NIRP in place.

Supply-side solutions have only been applied on a large scale to the subjects of bank bailouts, such as Ireland, Greece, Spain, and Cyprus. Deficits are still high throughout Europe, and will get higher yet given the calamitous Middle East/North Africa (MENA) refugee crisis. Catalysts for the European markets as value plays might include cheaper energy costs and better dividends.

However, the financial sector problems seem to trump these potential catalysts, at least in the short term. In other words, taking Europe as a whole, it seems very likely that European markets do not really represent a cheap relative value play, but rather another series of national-scale value traps delivered courtesy of the EU, the ECB, and their respective national governments.

U.S. investors who are trying to gain from diversification are apparently left with emerging markets as the lone remaining foreign value play that could be considered viable. On the surface, they definitely are cheap-appearing, since the price for an emerging markets ETF (NYSEARCA:EEM) has fallen by over 40% since it peaked in May of 2011.

However, most investors are aware that there are big problems in emerging markets, and that they may soon face a financial crisis of their own. Indeed, analyst Niels Jensen has suggested that we are entering a possible Phase III of the Great Financial Crisis (GFC) which will feature a breakdown in emerging markets.

More Apparent Regional Value Traps:

Massive capital outflows since the U.S. Federal Reserve said they would raise rates in calendar year 2015 have triggered currency interventions in many countries, according to economist Ed Yardeni. In the trailing 12 months through October 2015, these outflows forced EM central banks to intervene in forex markets, drawing down their currency reserves by about $800 billion.

The severe commodities collapse since 2011 has done lots of corporate damage and has hurt the tax revenues of many countries in the EM world. In those countries (such as Venezuela) where money printing has come into vogue to offset lower tax revenues and economic decline, hyperinflation and currency devaluation are the order of the day, with default waiting in the wings.

Debt in the EM countries has almost tripled in the eight years since the GFC. Now that many think that the debt may have to be paid back under pressure from a rising dollar, there is a mad scramble to pay back dollar-denominated debt (which is about 40% of the total) earlier rather than later. Hence, the aforementioned capital outflows. So although expected future returns for EM markets are considerably better than those for DM markets (as shown by GMO Research and others), the short-term risk in these markets is very high.

Summing all of this up, it would seem that diversification into foreign markets by U.S. investors could only work on pretty long time scales. In the shorter term, the risk is asymmetric to the downside, mainly because of the tendency of national governments to build better value traps over time.

Disclosure: I am/we are long SCZ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.