Japan: Museum Piece: Japan at Macro Vision

Investor attitudes

During client visits in the US last week and at the formal session of Macro Vision (Morgan Stanley’s annual conference in New York on the global macroeconomic outlook), the word ‘Japan’ was virtually absent. When discussed at all, Japan was mentioned as a museum piece, i.e., an example from history, relevant to the current world only as a lesson about what happens when there are severe and prolonged policy failures. Indeed, the most common question was whether the US is repeating Japan’s errors that led to the lost decade.

The similarities between the US subprime problem and Japan’s financial meltdown are eerie, but there are many differences too. In both cases, there were imprudent borrowers, imprudent lenders and unprepared regulators. Disclosure was inadequate, and financial innovations worsened the problems – since neither markets nor regulators fully understood the implications of the new instruments. The differences are important as well. In the US (and in Europe), institutions have been relatively quick to admit problems and to raise new capital. Broad and deep capital markets, clear standards on capital adequacy and regulator scrutiny have been contributors to this swifter response. Hence, most investors concluded that it will not take the US a decade to correct the subprime/credit problem. For investors in Japanese assets, however, this news only dulls the pain of the impending US economic slowdown on Japanese firms.

Thus, the bulk of foreign investors are unlikely to trigger a surge of Japanese equities. This attitude stems not only from adverse macroeconomic developments in Japan (such as consumer sentiment collapse), but also from the atmosphere in the US and the global economy. So long as subprime problems, credit problems, the global slowdown and high energy/agricultural price problems remain, it will be hard to convince investment committees in the US to raise weightings in Japan.

In the hallways

The hallway chatter about Japan at MacroVision was somewhat different. The many seasoned international investors at the conference are quite aware that Japan can change quickly. Many were among the beneficiaries of the sharp surge of Japanese equity prices in May 2003. They see extremely low valuations for many Japanese companies, even after considering the potential for far worse-than-expected earnings. Indeed, there were several mentions of technical indicators, such as the low P/B ratios and high dividend yields relative to JGB yields (both of which are cited by my colleague Naoki Kamiyama in his bullish arguments).

However, while seeing value, US investors are not ready to buy Japan, because they are afraid of a value trap. A catalyst is needed to release the value. With macro policy going back toward old-style pork barrel and with old-guard boardrooms feeling protected by recent court rulings, there is no catalyst in sight. The essence of this attitude was summarized perfectly by a seasoned, Japan-savvy client at the end of the conference: “Call me when something interesting happens.” At least he is willing to take the call.

What’s the trade?

For investors, Japan is a particularly sticky problem. Neither the direction nor the timing of any turnaround in the economy or corporate performance is clear. One simple response is to avoid Japan altogether. However, this response has an opportunity cost, in case there is a sudden move in markets. For investors worried about that opportunity cost, the response depends on investment style.

When investment philosophy allows, options strategies are another possible response. The pessimist’s strategy is a Japanese securities strangle. Even the pessimists acknowledge that low valuations in Japan imply a potential upside. They also acknowledge that Japan can turn on a dime. So, even for pessimists, upside protection is needed. However, if Japan remains on its current path, share prices could fall even more. Thus, one might want to buy both calls and puts, in amounts and with strike prices that suit one’s portfolio and opinions. Such a position would cost money to maintain, but would allow one to sleep at night while concentrating on other markets.

The optimist’s strategy is a costless collar. The logic here is that the downside may be limited. After all, even though earnings may fall, valuations are already very low. Moreover, Japan has underperformed other global markets recently. The upside, although uncertain in timing and extent, is large, in light of the huge hidden value on Japanese balance sheets and the potential impact from a return to the reform agenda. Hence, an investor may write puts and use the premiums to buy calls, in amounts and with strike prices that suit one’s portfolio and opinions. Such a position would be costless in terms of money, but not sleep.

For long-only investors, another possible response is to prepare buy-lists, and then to start buying when clear signs of an upswing emerge. Depending on the orientation of a portfolio, there are likely to be highly undervalued stocks in Japan that will rise sharply if sentiment turns positive. Even though such a strategy may not be able to call the bottom perfectly, significant increases of value are possible.

A final caution comes from recent experience. In September last year, my trip to Europe revealed uniform pessimism. I described this pessimism in Love’s Labor Lost (September 24, 2007). The response was immediate and overwhelming. Investors bought the market in droves, on the view that, when pessimism is so universal, the market must be a buy. Since then, TOPIX has fallen by 14%.

By Robert Alan Feldman Tokyo
Morgan Sranley
January 21, 2008