Brokers and others have proclaimed the bottom of the Japanese market so many times in the past it is...
Brokers and others have proclaimed the bottom of the Japanese market so many times in the past it is tempting to dismiss the current Topix rally ' around 30% since April 2003 ' as an aberration before another leg down.
However, there is more reason to be optimistic this time. What was missing before were reasonable valuations. But now, for the first time in 10 years, there are large chunks of the market trading on valuations comparable with those elsewhere in developed markets. One can argue that Japan should perform in line with developed global market indices ' other things being equal ' now the premium is gone. Further shift in sentiment should lead to more reduction in underweight to Japan and Japan's outperformance to global benchmarks.
It is remarkable the rally occurred in the face of massive selling by domestic institutional investors, in particular corporate pension funds that are returning a so-called 'proxy' portion of their funds back to the government, a process known here as daiko henjo.
This selling has been absorbed by still more massive foreign buying, which started in earnest in April. As foreign investors turned bullish, domestic retail investors also jumped in. As a result, trading volumes have risen sharply, regularly exceeding one billion shares traded per day, something not seen since the beginning of the bubble collapse. Domestic retail participation is not a negative: there is nothing wrong with some animal spirits and, besides, domestic speculators tend to get their timing right.
The earnings picture is looking brighter. Overall, companies revised up their full year recurring profit estimates by several percentage points when they announced their first quarter earnings (April to June of Japanese fiscal year ending March 2004). Some have postponed upward revisions until the end of the Japanese second quarter (ending September 2003), simply to be on a safe side. Even as an improvement in overseas demand was a factor in some exporters' revisions, cost cutting has remained the underlying theme for most domestic demand-related names. There seems more scope for upward revisions in operating profit in the second quarter and beyond.
The economy is in reasonable shape and any pick-up in domestic or, more likely, external demand should translate into growth. Consider that absolute level of manufacturing inventories in the economy is at a 1988 low and is still coming down, and that inventory-to-shipments ratio shows no signs of excess.
There are encouraging signs in the growth of private sector capital expenditure and relatively stable domestic consumption due to lower savings rate. Better-than-expected numbers just recently sent sell-side economists revising up their FY3/04 and FY3/05 GDP forecasts.
Importantly, the improved sentiment regarding Japan is largely due, in large part, to lesser concerns about Japanese financial system. The decision to recapitalise Resona Holdings took just 30 minutes to make in an emergency cabinet meeting on 17 May. The government showed it was willing to push the banks hard to clean up bad debt and, in this process, it would not tolerate any disruption to the banking system. Subsequently, the old management was forced to resign en masse and without pension benefits. Investors were protected, which set in motion a rally in major bank stocks.
When Heizo Takenaka, head of the Financial Services Agency, issued a business improvement order to major banks in early August ' essentially saying stay profitable or else, there are reasons to believe the banks will listen. There will be more restructuring and cost-cutting, a positive for the market.
Aside from banks and brokers, it was mainly cyclical, capex-related names that drove the current rally: steel, machinery, trading companies and paper and pulp. Electric machinery and telecoms also did well.
However, on the downside, it was mainly the defensives. The magnitude of the turnaround in sentiment in capex-related names is such that they are still opportunities for more outperformance there. In many cases, they are finding out that dogs of old Japan have managed to cut costs and meaningfully concentrate their products in profitable lines. Also blue chips should stage a comeback relative to the broader market as investors up-weight Japan in their portfolios and go for the most liquid names.
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