No silver bullet for Japanese Stocks

Geisha are traditional, female Japanese entertainers whose skills include performing various Japanese arts such as classical music and dance.

Another day and I receive another piece of bullish commentary about Japan. This time a financial newsletter writer who is taking credit for predicting in November that Japanese stocks were set to soar. (We rarely get reminded about his – or anyone else’s – bad calls…)

In November, Japan’s Prime Minister Shinzo Abe had just said that he wanted Japan to print “unlimited sums” of Japanese yen. This monetary stimulus is supposed to weaken the yen against other currencies, increase price inflation to around 2%, and generally get the economy going after more than two decades of stagnation.

Here’s the bullish theory. If the yen is weakening then Japanese exporters will be able to sell their products at lower prices in foreign countries. And if they can sell at lower prices in those countries then they can sell more products to foreigners. So foreign profits at Japanese exporters should increase, which means Japanese share prices should go up. Buy Japan!

Japanese shares are up 42% in the last four months, as measured by the Nikkei 225 index. It’s gone from 8,676 to 12,315. An apparently impressive jump.

But hold on there! There’s something we need to check.

Yes Japanese stocks are up, but not as much as it appears at first glance. The Nikkei 225 measures prices in Japanese yen. But the whole reason for all this sudden bullishness is Abe’s project to weaken the yen. So what if we look at progress of Japanese stocks when measured in other currencies?

Let’s start with dollars. The yen has fallen 17.3% against the dollar over the past four months. So that 42% yen gain gets cut in half when we express it in dollars. It comes down to 21% (142% divided by 117.3% equals 121%). The results are almost exactly the same as dollars when measured in Swiss francs and Indian rupees.

Looking at Brazilian reais the devaluation of the yen has been 20.7%. Suddenly the four month gain of the Nikkei is cut to 17.6%. Measured in euros it’s 19.1%.

Japanese stocks have jumped on the news of unlimited yen printing.

So yes, Japanese stocks have jumped on the news of unlimited yen printing. But because the yen is collapsing, the trading profit for foreign speculators is much less impressive. Only local Japanese investors will have felt like they have made 40% plus gains.

There’s an important point here for investors. You need to remember to assess all investments using your own currency, or some other consistent benchmark like US dollars. Any stock chart can look like it is heading for the stars if the underlying local currency is weak enough. But that doesn’t mean that foreign investors have been making profits.

A lot of people think in dollars if their country has a particularly dodgy home currency – such as those that live in Argentina or Venezuela. Dollars are still accepted in most places in the world, so it makes sense for many people outside the US to use them as a “unit of account”.

Shinzo Abe wants to go down in history as the man who finally turned around Japan’s zombie economy. He wants to be the saviour who returns it to growth. But there is no silver bullet for Japan’s problems.

Shinzo Abe has been performing like a Geisha. His skills include printing Yen and driving Japan to a hyperinflationary depression. (Photo Kondo Atsushi)
Shinzo Abe has been performing for investors just like a Geisha. Just a little too much stimulus.  (Ph: Kondo Atsushi 2009)

He could just as likely end up being the man who condemns it to a hyperinflationary depression. Just a little bit too much stimulus and Japan could reach a tipping point, followed by a savage meltdown.

For example, everyone could start dumping Japanese government bonds (JGBs). 10 year JGBs yield a pathetic 0.64%. Why would anyone in their right mind want to own those, if inflation starts picking up?

If yields on Japanese bonds increase the Japanese government has a big problem. Japanese government debt is already 230% of GDP. And the government adds another 10 percentage points to that pile every year, because they run a huge budget deficit.

If yields go up, the Japanese government will have to pay more interest on future borrowing. This future borrowing comes from new debt to fund the fiscal deficit, and also to replace existing debt when it matures and has to be paid back. According to the IMF this requirements is now around 55% of Japanese GDP each year that must be borrowed for the first time or refinanced.

That’s a massive amount of debt to find buyers for!

At these kinds of levels the government debt bill could balloon in just a few years if JGB yields start to rise. The government will be tempted to print even more money to cover its bills. Then investors – both Japanese and foreign – could dump even more JGBs and the yen would fall dramatically.

Then investors – both Japanese and foreign – could dump even more JGBs and the yen would fall dramatically.

Japanese stocks would most likely be dumped also in the panic. It could turn into a full scale “Japan crisis”. Combined with the falling yen, foreign investors would lose most of their money.

The end result could be a hyperinflationary meltdown, where we see ordinary Japanese people using wheelbarrows full of yen to buy a little rice for lunch.

People get poor slowly in a deflationary depression – but at least they have time to react.

People get poor very fast during hyperinflation, as their savings become worthless overnight. There is little time to react.

We can’t know exactly what will happen in Japan, or when. But it is obvious that the huge debt pile and the money printing policy both present huge risks to Japan’s future. Abe is doing nothing more than a massive monetary experiment, and the results are highly uncertain.

So be careful about following the bullish speculators into Japanese stocks. This fashionable trade could reverse at any time.

But even if this disaster scenario is avoided, the question you need to ask yourself is: Should I buy Japanese stocks at current levels? My answer is a firm “No”.

According to the Financial Times, Japanese stocks have a P/E ratio of 16.7x and a dividend yield of just 1.9%. To me this looks like Japanese stocks are already fully priced, even slightly expensive for a low growth economy. This isn’t bubble territory, but neither is it cheap. Buy-and-hold investors will need a lot of future earnings growth to make a decent return.

The initial “good news” rally has already passed. Japanese stocks could continue to rise in the short term, as momentum traders keep piling in. But long term investors that like to buy things when they are cheap – the kind of sensible investing we encourage at Of Wealth – should look outside of Japan for their profits.

Until next time OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.