A Death Struggle With Time

The Daily Reckoning Presents: A guest essay in which the author speculates on deflation, capitulation, and the “silver generation” in…er, “J”…


Capitulation is that delicious moment when investor sentiment is so bad that no one wants to catch the proverbial falling knife even though it has landed on the floor with a thump. It is that moment before dawn when it is most dark. The Fat Lady has sung, the party’s over, and investors have thrown in the towel.

Capitulation is that moment when every negative cliche has been used by newsletter writers.

Clearly that moment hasn’t arrived in equity markets in the United States or Europe. After selling-off quickly following the tragic events of September 11, equity optimists rushed back into the market to buy on what they perceived as the mother of all dips.

There is, however, another economy, and another stock market, far beyond the wailing sirens of lower Manhattan, where the echoing call of “capitulation” can be heard: Japan.

For 30 years, Japan was the national warrant for investors eager for an Asian comeback play after the Second World War. Today, Japan is the world’s most celebrated economic basket case. This once-mighty, just- in-time export engine has fallen so hard, and for so long, that even the most die-hard bulls are giving up.

The question before investors is whether Japan has reached that stage of capitulation and whether it is now time to get back into the market. I will argue that never in modern history has investor sentiment been more bearish about Japan.

Certainly, the signs of capitulation are everywhere. Consider: at the height of the September 11 crisis, CNBC analysts almost laughed when they reported on equity markets in Japan. “The Nikkei down another 500 points,” muttered one. “Yeah,” said the other. “A real mess.” Capitulation.

“My patience has run out,” Morgan Stanley’s legendary fund manager Barton Biggs recently told Asiaweek. “I’m tired of waiting for a recovery.” Capitulation.

“Asset quality is worse than even we had believed,” Goldman Sachs banking analyst David Atkinson’s recently wrote in a report entitled “Totally Rethinking Japanese Asset Quality”. The report concludes that a “bottoms-up” analysis suggests total bad debts of 237 trillion yen. Please don’t adjust your reading glasses. This isn’t a typo. Goldman Sachs thinks Japan’s listed companies are sitting on more than $2 trillion in bad debt. Capitulation.

“The Japanese economy is a mess,” Kiichi Miyazawa, Japan’s finance minister until last year, grimly admitted, and “I really do not know how to get out of the current situation.” Miyazawa’s public service stretches back so far that he was part of the Japanese delegation that signed the U.S.-Japan peace treaty in San Francisco in 1952. He was the man who, as prime minister, offered a helping lap to then President George H.W. Bush when he had an adverse reaction to Japanese food in 1990.

When one of the most powerful ministers and politicians of the postwar era of Japan admits he has run out of ideas, that is a classic sign of complete capitulation.

Why are things so bad in Japan?

Probably the most asked question by any visitor to Japan is why, if the economy is so bad, does everyone in Tokyo seem so prosperous? It’s true, the new Ginza Hermes store is doing a terrific job selling handbags and ties to free-spending young professional women. Families are flocking to the new Universal and Disney theme parks in Osaka and Tokyo. Until just recently, Porsche, Ferrari, and Mercedes were enjoying robust sales.

And yet the daily economic news out of Japan is unrelentingly grim. Property prices have collapsed. The Nikkei is at an 18-year low. It recently made history falling below the Dow! There once was a time when the Dow was at 2,000 and the Nikkei at more than 30,000.

With the market in full swoon, so is business and consumer sentiment. The Tankan Business Condition survey is bouncing like a dead cat. At the same time, deflation and unemployment are accelerating at a record pace. The Bank of Japan is feverishly printing money to weaken the Yen and trigger inflation. Government debt to prop up the economy is at more than 130% of GDP.

Entire forests have been cut down as analysts and economists try to figure out what is wrong with Japan. [Not to mention more than a few gigabytes of bandwidth used up by your editors at The Daily Reckoning…]

“The lever that Japan ought to be able to use to ensure its survival and leadership in the new economy is, of course, its financial capital,” offers Bart Broadman, chairman of J.P. Morgan in Japan. “Certainly, it has a lot of it. This is a nation flooded with Yen savings.” The problem in Japan, however, isn’t the availability of capital, but rather how it is used.

“How can the nation compete long-term in a dynamic global economy, when it is hobbled by troubled financial intermediaries and is compulsively risk averse? Capital that is not being recycled from yesterday’s losers to tomorrow’s winners. There is none of the creative destruction process that we have learned is so critical to long-term economic success,” says Broadman.

This may also answer the question of why Japan seems so prosperous in such lean times. The post office now holds $2 trillion in savings. Japanese government bonds, representing the safest investment available, are at record low yield levels. A two-year bond yields 1/8 of 1%. The massive imbalance of capital allocation means there is a lot of money out there to be spent on Chanel scarves and trips to Tuscany, but almost no capital available to fund new entrepreneurs and their business ideas.

Excessive risk aversion is killing any entrepreneurial spirit in Japan. Ironically, Japanese entrepreneurs have to look to imported capital, while living among vast pools of risk-averse domestic capital. John Lipsky, Chief global economist for J.P. Morgan, pins all of Japan’s problems on another issue: consumer sentiment. I would agree.

Recently, I was having a chat with one of our most senior Japanese bankers. Yes, I told him, I understand all the economic concerns. Now, please, tell me the real problem.

“It’s a generational war,” he said. “The old have the money, the young want it, but the old are not about to give it up.” The problem is getting worse by the day as the nation ages faster than any other country on earth.

With the so-called silver generation controlling most of the nation’s assets, be it land, Yen, or gold, the risk appetite in Japan has never been more conservative.

Adding complexity to the issue is that this generation is also the most politically active. They are the primary beneficiaries of a gerrymandered political system that essentially freezes out Japan’s largest cities – and the young people who live there – from the political process.

This silver generation, which worked so hard to rebuild the nation from the radioactive rubble of the Second World War, not only controls the “gold”, but the political fate of the nation. And this generation has no intention of embracing the “no pain, no gain” economic reforms suggested by Prime Minister Junichiro Koizumi.

The risk-averse nature of this generation shouldn’t come as any surprise to anyone whose parents came of age in the Great Depression of the 1930s. Take my mother. She doesn’t realize how much she shares in common with her silver peers in Japan.

At 79, she is a master of Depression economics. We were all indoctrinated on its core fundamentals: never borrow or lend; never get into debt – even with credit cards; balance your check book; never speculate on real estate, but own a mortgage-free home that you live in. Never, ever live beyond your means. And if you must gamble, dabble in the stock market; it’s cheaper than horse racing and more socially acceptable dinner conversation.

Sound advice from a cagey social doyenne from the cave- dweller land of Washington, D.C. And today, anyone in Japan who had followed my mother’s advice would be way ahead of those who invested in stocks. There are other lessons from the Depression. My father was raised by two old Victorian aunts in Boston during the Depression. He used to say he never had it so good. Each month the value of the coupons his auntie clipped grew in value as deflation accelerated.

And over in England, my wife’s Oxford-educated but capital-starved BBC journalist parents came of age in the grim days following the Second World War. For their whole lives they have scrimped and saved in a manner that would make even my family blush. Yet, on both sides of the Atlantic, most of my family sits with modest amounts of real estate, not a dollar of debt, and enough cash on hand to keep life pleasant. And so too does much

of Japan.Any family that ignored those pesky Nomura, Merrill, or Daiwa salesmen and did absolutely nothing more with their money than stuff it under a futon is looking pretty good. Yen collected in kitchen jars or in the government equivalent – the post savings system – has achieved a far greater return than a long-term investment in a basket of Japanese stocks.

Why? Deflation.

While deflation is a nightmare for government budgets, businesses, and financial firms, it is a godsend for most Japanese, particularly retired ones. Those seemingly laughable returns from postal saving deposits are now creating real returns of more than 2%.

Deflation investing has done the consumer well in Japan. Pensions are worth more, as the price of everything from apples to coffins has plunged in Japan. Real estate prices have dropped, of course, but if there is no plan to sell, who cares? There is something in the spirit of postwar Japan that loves this kind of austerity.

While their daughters are buying Chanel, Mom is countingthe number of toilet sheets to be used, or sending Dadoff to work with a few hundred Yen in his pocket. Thisis great for the family budget, but spells disaster forthe economy. Private consumption is 63% of GDP, which iswhy our economic gurus at J.P. Morgan describe theeconomic situation in Japan as “dire”.Japan, then, is in a death struggle with time. The macroeconomic indicators keep getting worse. Foreign pressure to reform is getting louder by the day. Yet, each day more and more Japanese retire into a deflation paradise where their hard-earned Yen gains value. Every effort by Japan’s Diet to reform the economy is met by a wave of opposition from this conservative majority.

No doubt, the economic and financial problems Japan faces are as difficult as any developed economy has ever experienced. But don’t mistake difficulty for adversity. Japan isn’t Indonesia, Argentina, or Turkey. To the contrary: it owns most of the U.S. debt. There is no way to really pressure Japan, particularly with tens of thousands of U.S. troops living in Japan on the invitation of the government. As Jesper Koll at Merrill Lynch always likes to point out, Japan could survive for years, perhaps decades, living off the fat of the money it has saved.

All the experts agree there can be no economic recovery until the bad loans are resolved. Getting rid of bad loans really means doing radical surgery on the Japanese economy. It means thousands of bankruptcies, soaring unemployment, and a dismantling of the Japanese social welfare system as we know it. However, being serious about resolving the NPL issue will also trigger the kind of generational reaction that has and will continue to stop real reform for quite some time.

So, what does this all mean for investors in Japan? Hold on to your wallet. Chartists will say that this may be a historic opportunity to invest in Japan. They said that when the Nikkei was at 20,000. And again at 16,000. And yet again at 12,000. Now it’s around 10,000. My guess. When the Nikkei falls below 6,400 – calling Mr. Greenspan – then I believe the country will truly be in trouble.

Things are going to get a lot worse in Japan before they get better, if ever. This writer has capitulated.

Peter McKillop,
November 21, 2001

for The Daily Reckoning

Peter McKillop is a former New York bureau chief for Newsweek where he covered, among other things, the stock market crash in 1987, and a foreign correspondent in Hong Kong and Tokyo, where he covered the collapse of the Japanese bubble in 1992. After nine years in Japan he continues to write about the country for Time magazine’s website. He now works as a vice president in charge of corporate communications for J.P. Morgan in Japan.

A version of Mr. McKillop’s essay first appeared in The Gloom Boom and Doom Report, published by the Blue Team’s Dr. Marc Faber. For investment ideas consistent with those you read in the Daily Reckoning please click here:

Terror In The Streets

“Your advice has cost me a lot of money in the last few weeks,” said an English Daily Reckoning reader last night.

I had just given a speech to a group of readers at the Caf? Royal in London, explaining why stocks were more likely to go down than up. Not everyone was convinced. “The rally may not last forever,” my interlocutor continued, “but then, they never do, do they?”

No, they never do. Typically, Mr. Bear takes a break after mauling a market. Prices almost always recover somewhat – often rising to retrace half the loss. That’s about where the market closed on Monday night.

After nearly two decades of rising stock prices, there’s a momentum of confidence that takes a long time to reverse direction. Investors still believe the Fed’s lower rates will revive the economy – if not the first 10 cuts…perhaps the 11th! They still have faith that long-term, buy-and-hold investing will pay off…if not this year, surely the next!

And as stock prices rebound, investors quickly regain their old confidence…believing the hard times are over.

“Alas, for me, [the rally] still looks like a head fake,” writes Stephen Roach. “In a climate of rising unemployment and declining personal income growth, conditions are ripe for a classic consolidation of discretionary consumption.

Financing and/or price incentives can only defer the inevitable…the post-incentive fallback could be even more severe. The same can be said for the impact of home mortgage refinancing activity…By our estimates, even with the October retail sales spike, real consumption growth in 4Q01 should still come in around “zero.” Imagine what that number would have been without refinancings and cut-rate financing of motor vehicles! Or without the tax rebates! Or without the drop in energy prices!”

“Demand is running on fumes,” Roach concludes, “…the ‘V’ shaped recovery remains a pipe dream…”

And yesterday, the rally may have come to an end…Eric?


Eric Fry in New York…

– News Flash! Abby Joseph Cohen is Bullish!…The stock market fell anyway.

– The Dow dropped 75 points to 9,901, while the Nasdaq tumbled nearly 3% to 1,880. Oh well, perhaps today will be a better day to be bullish than yesterday.

– Bill and I take a slightly more matter-of-fact (read: cautious) approach to this market of ours. “The expensive stock could become less expensive,” Bill reasoned in yesterday’s Daily Reckoning. “So, we stick to the essentials…Buy low, sell high. No more essential rule of investing has ever been formulated.”

– Investors do well to remember this basic rule of investing, especially when the stock market gets a little nutty. When “Buy high…sell higher” is working so well, it is easy to get confused.

– Many things succeed for a time: like jumping off a bridge in order to fly; setting your couch on fire in order to keep warm; or marrying several wives in order to enjoy domestic bliss.

– At the current quote, the S&P 500 Index sells for more than 30 times earnings and yields a fulsome 1.37%. That’s rich folks…no ifs, ands, or buts.

– Not to worry, says Goldman’s Abby Joseph Cohen, stocks will “continue to do well.” The market’s strong advance since late September is “well-supported by intermediate- term fundamentals,” Cohen assures the faithful. What exactly are these bullish “fundamentals?” Let’s listen in: “Fourth-quarter earnings will be exceptionally ugly,” Cohen says. “But it won’t matter to stock prices. That’s because most investors expect improved earnings in 2002.”

– Can’t argue with that unassailable logic. Cohen thinks the Dow could easily reach the upper range of her “price target” at 12,400. “Investors are no longer solely focused on potential terror and risk,” says Cohen, “[but are] again making decisions balancing investment risks against potential returns.”

– But what about terrifying investment risks? Don’t those count for something? With all due respect to Ms. Cohen, the stock market appears to be overreacting to the prospect of economic recovery.

– James Stack, editor of InvesTech Research, offers a more sobering assessment of the current market action. “Bubble excesses take a long time to resolve,” Stack explains.

– “There are still many technology stocks that are operating on a non-functional business plan. In other words, they are still burning through cash faster than they can earn it. So there are many [companies] – still clinging to life – that are simply not going to survive through the slow growth ahead.”

– Furthermore, says Stack, “the popping of this bubble has not taken valuations (i.e. overall P/E ratios) down to acceptable norms…We think it could be years before the NASDAQ index recovers to 3,000, let alone seizes the old high of 5,048.”

– Abby? Any rebuttal?

– “Buy low…sell high” is not only an essential investment dictum, it is also a fairly obvious one. But – like chastity – it is a principal that is easily forgotten in the passion of the moment.

– It’s a funny thing about investing that risky practices sometimes masquerade as prudence. Almost any strategy – however ridiculous it might actually be – can work brilliantly for a while, and seem therefore like a perfectly safe course of action.

– By contrast, even the most reasonable long-term investment strategies can perform poorly over the short run. But investors do well to remember that short-term success is not the same thing as low-risk success.

– If your next-door neighbor leaned over the fence one day and said, “You know, I figured out the perfect way to shave 15 minutes off of my daily commute…I run every red light.”

– Would we thank our neighbor for divulging his brilliant strategy? Or would we suggest to his spouse that she start shopping for a casket?

– Yet, when someone we know boasts that they’re making a killing in the market by buying pricey stocks, we feel like we’re missing something. We feel like they must really know something that we don’t. Guess what? They don’t.

– The NASDAQ’s gut-wrenching collapse over the last year and one-half – a period which saw this go-go index lose three-quarters of its value – tells you everything you need to now about the durability of profits produced through high-risk means.

– So many investors were running red lights in early 2000, that it seemed like no harm could ever come to them. And then suddenly, everything started crashing.

– Running red lights is dangerous, even on Wall Street.


Back in London…

*** “A rebound in search of a reason,” wrote Gretchen Morgensen of the current (recent?) rally. But if it goes on long enough, imaginative bulls will find reasons enough to justify it.

*** They’re already re-inventing the myths of the bubble…as reasons for a new bull market.

*** Remember the “Peace Dividend?” It was a collateral benefit from what Francis Fukayama called “the end of history.” Democracy and capitalism were triumphant, we were told. So there would be no more wars or revolutions – history had run out of material. The fall of the Berlin Wall was supposed to eliminate the need for big defense budgets – releasing capital for other purposes. But then, the WTC and the Pentagon were hit by terrorists and history was, well, resumed. And now we have the “war dividend,” in which all the spending on the war against terrorism is meant to stimulate the economy.

*** Likewise, during the Bubble era, stocks were supposed to go up because the Greenspan Fed would make sure there would be no recession. No recession, no fall in earnings. No fall in earnings, no need for stock prices to go down. If stock prices never went down, they must only go up…and therefore were good buys no matter how expensive they were.

*** But then, the Fed failed. The entire world economy, according to a yesterday’s OECD report, is in recession. And stocks lost about $4 trillion of value in America alone. So, now we are told that that the Fed that was not supposed to allow a recession is nevertheless able to cure the one we have…and that the 11th or 12th rate cut will do the work that the first 10 failed to do… and that we should buy the stocks that could never go down because they are cheaper now!


The Daily Reckoning