Buying Tokyo

A prime investment opportunity in…Japan? "For contrarian investors," argues the Oxford Club’s Alexander Green, "now – when abject pessimism about the country’s future is at its zenith – may actually be an historic buying opportunity…"

Japan is 14 years into an economic crisis. In fact, the world’s second-largest economy has been stagnant for so long it has essentially abdicated its once-leading role in Asia and the global economy.

There are several reasons for this. The country experienced a huge bubble in its stock market in the late 1980’s. (In fact, this bubble bore more than a passing resemblance to the technology stock mania of the late 1990’s.) In 1989, Japan’s index – the Nikkei 225 – soared to 39,000 and more than 100 times earnings. It was accompanied by an equally magnificent real estate bubble.

Unfortunately, Japanese banks were busy lending money against these pie-in-the-sky real estate values. More than a decade later, property prices in Japan have fallen over 80%, devastating the Japanese banking system.

In the early 1990’s, the U.S. had its own massive problem in the savings and loan industry. The Resolution Trust Corporation was formed to clean house. And it did.

Nothing like this has happened yet in Japan. So far, the country’s inept political system has refused to address the problem. As a result, the Japanese economy stumbles along, zombie-like, while its bankrupt banking system continues to lend money to technically insolvent companies.

Japanese Banking System: More Pork than Oscar Meyer

Politicians in Japan have made the situation even worse. Rather than cutting taxes sharply to stimulate the economy early on, the government enacted huge spending programs to stem the economic decline. This involved massive public works projects, including highways that weren’t needed and bridges to nowhere. In short, Japanese taxpayers saw more pork than the average butcher at Oscar Meyer.

Needless to say, it didn’t work. The dysfunctional banking system and the huge budget deficits resulted in a relentless deflation that has been eroding prices in Japan for over a decade. As a result, consumers – ever fearful that things will get even cheaper – refuse to spend. And that has caused the deflationary cycle to grow ever more vicious.

In fact, things have gotten so bad that last year Moody’s took the unprecedented step of downgrading Japan’s credit rating from A1 to A2. That’s lower that Botswana’s.

All in all, over the past decade and a half, Japan has seen the bursting of an investment bubble…a sickening deflationary crisis…a market index that has plummeted 82%…and the emergence of a very black mood among consumers and investors. Yet for contrarian investors, now – when abject pessimism about the country’s future is at its zenith – may actually be an historic buying opportunity.

Japanese Banking System: Serious about Banking Reform

There is a strong case to be made that Japanese shares are greatly undervalued. For starters, the Japanese government is finally getting serious about banking reform. It’s true the ruling Liberal Democratic party continues to try to foil the initiatives of the Koizumi government. But as the crisis has escalated, intense pressure to make meaningful changes to the banking system keeps growing.

Secondly, real estate prices have now fallen much further than rents. Many Japanese properties now yield more than 10% annually. That provides support for real estate at these levels and indicates a bottom is at hand. With returns this high, it’s unlikely Japanese property values will fall dramatically from here.

Another positive sign is that Japanese profits are already on the upswing. According to Morgan Stanley, profits for listed companies in Tokyo (excluding banks and other financial concerns) rose 80% in the fiscal year that ended in March.

Yet by many measures, Japanese stocks are among the cheapest in the world today. An amazing 60% of Japanese listed companies have a market capitalization that is lower than the value of their net assets. (U.S. companies in the S&P 500, by comparison, sell for more than five times this much.)

More importantly, every bit of bad news detailed above is already reflected in Japanese share prices. No one is going to sell Japanese stocks today based on the gloomy news of the past decade. But a glimmer of positive news – like genuine banking reform – would drive Japanese share prices substantially higher.

And that may happen soon. The Japanese people have socked away more than $250 billion in cash. Unfortunately for these thrifty folks, Japanese government bonds pay only a smidgen more than nothing. (Mortgages of less than 1% are commonplace.) When the stock market begins to gather steam, huge sums of cash are likely to leap from the sidelines, adding fuel to the fire.

Japanese Banking System: Severely Underweighting Japan

As chief economist Stephen Roach of Morgan Stanley put it, "the Japanese consumer may represent the greatest source of pent-up demand for a major economy in the modern era."

Finally, it’s important to note that global money managers have managed to beat the international index over the past decade just by severely underweighting their exposure to Japan. If the Japanese market starts to take off, they will be forced to invest billions to keep from underperforming their benchmark.

And let’s not forget that Japanese stocks provide a wonderful dollar hedge. If the dollar falls 20% against the yen, for instance, Japanese shares will be worth 20% more in dollar-terms, even if the Japanese stock market goes nowhere.

There is risk in this scenario. By backing away from meaningful banking reform, the Japanese political leadership may end up winning the Rubber Backbone Award. Or some other yet-unknown screw may come loose.

For that reason, I’m recommending a conservative way to capitalize on a rebound in Toky buy the whole market.

Just as you can buy an index fund based on the Dow, the S&P 500 or the Russell 2000, so too can you buy a publicly traded index fund that replicates the performance of the Japanese market. It’s called the MSCI Japan Index Fund (AMEX: EWJ).

This is the most heavily traded international index in the U.S. And it has plenty of liquidity, with more than $1 billion in assets. It’s made up of many companies you already know and patronize. For instance, the top ten holdings – which make up over a quarter of the fund – include Toyota, NTT DoCoMo, Canon, Sony, Honda and Nissan, among other well-known international brands.

Buying the Japanese market today is contrarian investment at its boldest. But as investment legend John Templeton has often said, "the greatest bargains can only be found at the point of maximum pessimism."

Sell New York. Buy Tokyo.

Regards,

C. Alexander Green,
for the Daily Reckoning

August 14, 2003

P.S. True, there is risk investing in Japan. But the potential upside more than justifies it.

Japan’s economic woes are well-publicized worldwide. So the average investor – to the extent that he considers the Japanese market at all – thinks investing in this part of the world is absurd. And that, of course, is why it’s such a splendid contrarian investment opportunity.

Mr. C. Alexander Green, a fifteen-year Wall Street veteran, is Investment Director of The Oxford Club. In addition to writing on global investing for Wall Street Week’s Louis Rukeyser, he has been a writer or contributor to several financial publications, including Global Insights, Short Alert, Insider Alert, The Financial Sentinel, World Market Perspective, and the US edition of The Fleet Street Letter.

There are only two major emotions on Wall Street – greed and fear. Events are meaningless in themselves. Even the murder of an Archduke or the burning of the Reichstag might have had happy endings, for all we know.

From a short-term investment standpoint, it is not the event itself that is important…but how it is spun in investors’ minds. At market bottoms, everyone is fearful and almost every event is considered an omen of doom. At tops, on the other hand, it is hard to find an event that doesn’t spin happily in their thick skulls, like a top in a vacuum. In Tokyo, at the height of the late ’80s bubble, even an earthquake caused investors to celebrate; and in America following the destruction of the Twin Towers, commentators such as Larry Kudlow explained how this would cause a war…which would be good for the economy and the stock market!

And now we have the bond market collapsing.

What does it mean?

We don’t know, but almost all economists, analysts and TV newsheads are treating it as good news, as if it were equivalent to finding a liquor store that made home deliveries on Sunday.

We have a few essential insights here at the Daily Reckoning: busts follow booms…you can’t get something for nothing…and even the rosiest dawn of greed sooner or later gives way to a cold midnight of fear.

Our mission here is to squint and try to see things, not as others see them now, but as others might see them after the lights go out. Investors think rising bond yields reveal a pick-up in the demand for money – a sign that the economy is beginning to heat up.

But with our eyes wide shut, we think we see the outlines of something else: lenders are getting worried; they are asking for a higher return to cover the increased risk.

And if they aren’t, they should be.

The U.S. has been the biggest beneficiary of the Dollar Standard system; soon, Americans will be its biggest victims. The Dollar Standard monetary regime allowed Americans to buy things they couldn’t afford…and then not have to pay for them. Instead, they just gave out ‘dollars.’

Now, you can hardly turn over a rock or look under a seat cushion anywhere in the world without finding a U.S. dollar bill or dollar bond. And they’re increasing at the rate of about $1 million per minute. That’s the most recent measure of the U.S. current account deficit.

The world has never seen anything like it. But as night follows day, we know it will come to a bad end. But, unlike night following day, darned if we know when.

"How much longer will the rest of the world be willing to accept debt instruments from the United States in exchange for real goods and services?" asks Richard Duncan in his book, The Dollar Crisis. "It is only a matter of time before the United States will no longer be considered creditworthy. In fact, it really is only a matter of time before the United States will NOT BE creditworthy."

Mr. Duncan has the right idea. But his book may need an update. The U.S. is already not creditworthy…for there is no way it can pay off all of its debts and obligations with dollars of today’s value. The moment when investors will realize this, however, still lies somewhere in the dark night ahead.

We don’t know when the sun will finally set on the dollar and the Dollar Standard monetary system. But we think we hear the bell for vespers. Dollar holders…and bond investors…may want to say a silent prayer.

And now over to Eric Fry, our man in California…

————-

Eric Fry, checking in from San Francisco…

– Your New York correspondent – filing his report today from the left coast – arrived in San Francisco earlier this week to participate in the Agora Wealth Symposium. Yesterday afternoon, he strolled around the City by the Bay like a tourist, even though, in a former life, he lived and worked in San Francisco for eight years.

– The brilliant sunshine accentuated many visible legacies of the Internet boom years: immaculate new sidewalks, a palm-tree-lined Embarcadero, shiny refurbished trolley cars and innumerable 2-year old Infinitis and BMWs zipping up and down California Street.

– But this near-flawless, picture-postcard city was eerily quiet…its spotless sideways conspicuously underutilized. "Where are all the people?" your New York correspondent wondered to himself. "It was never this deserted when I lived here in the mid-to-late 1990s."

– Even the crowds of tourists – although certainly not the tourists themselves – seemed noticeably thinner than they used to be. The formerly standing-room-only cable cars offered plenty of sitting room. From a tourist’s perspective, there’s probably never been a better time to visit this delightful city. But what’s making this city hum? Who’s doing the work required to make the money required to pay the taxes required to shrink California’s gaping budget shortfall to something less than $40 billion?

– To be sure, one tourist’s observations are not conclusive proof of economic difficulty. Maybe San Francisco is doing just fine economically. Maybe the city’s high-tech inhabitants shun the sunlight like albinos, and huddle all day in front of their PC monitors, generating income in some kind of reclusive, high-techy sort of way.

– Ah well, the stock market bubble was fun while it lasted…but it is definitely over, no matter how hard Greenspan tries to resurrect it. In other words, the bursting of the stock market bubble is history. Meanwhile, the bursting of the bond market bubble is history-in-the- making.

– Bond prices crumbled again yesterday, causing long-dated Treasury yields to soar to fresh one-year highs. The 10- year Treasury note tumbled 1 6/32, pushing its yield up to 4.58%. The staggering bond market crippled the stock market as well, as the Dow Jones Industrial Average dropped 38 points to 9,271.76, ending a five-day winning streak. The Nasdaq dipped half a point to 1,687.

– The bond market remains THE story of the U.S. financial markets…which means that the mortgage-lending sector is at least A story of the U.S. financial markets. As interest rates soar, mortgage activity is evaporating. Mortgage loan applications dropped another 16.1% in the week ended Aug. 8, and are down about a third from the peak levels reached in May. If yields continue their meteoric ascent, the mortgage market will flame out like a supernova.

– Mortgage giants Fannie Mae and Freddie Mac may be flaming out already. Now that the 10-year Treasury yield sits a whopping 147 basis points above the yield of 3.09% it touched on June 13th, what good could possibly befall a mortgage lender, especially a highly leveraged, thinly capitalized, ultra-aggressive mortgage lender like Fannie Mae or Freddie Mac?

– Your New York editor has no personal axe to grind against either mortgage lender (although a member of his family is short one of the stocks), but as a seasoned observer of the financial markets…he suspects that the shares of these two financial giants are, best case, two of the most dangerous ‘longs’ in the U.S. financial markets.

– According to the New York Times, Fannie’s own ‘What if?’ scenarios from a few months back predicted that the company’s portfolio would suffer a $7.5 billion loss "if interest rates rose immediately by 1.5 percentage points." Guess what? 10-year Treasury rates have jumped 1.47 percentage points in less than two months. Does this mean that Fannie is nursing some multi-billion portfolio losses? Investors should not be surprised if this were true.

– What’s more, according to the Prudent Bear’s Doug Noland, Fannie Mae’s balance sheet is ill-prepared for adversity. "Fannie Mae ended June 30, 2000 with a Total Book of Business (mortgages held in its retained portfolio and mortgage-backed securities it has guaranteed) of $1.247 trillion," Noland calculates. "The company had an Allowance for Losses of $808.9 million, or 0.06% (six basis points) of its Total Book of Business…Over this period, the company has gone from $1 of loss reserve for every $1,541 of business exposure to $1 for every $2,537 of exposure…It will take some time, but the thinly- capitalized and fatly risk-exposed GSEs have (with the Fed’s assistance) placed themselves in serious harm’s way. I see no way for these institutions to now sidestep eventual collapse, unless speculative market dynamics are somehow repealed."

– Imagine a parent who stores crates of explosives under his baby’s crib and you will understand something about Fannie Mae’s approximate financial profile. Now imagine that the parents slide the baby’s crib and explosives over next to the radiator (in order to make room for more explosives) and you will understand something about Fannie Mae’s corporate philosophy: ‘But why worry; the explosives are unlikely to detonate.’

————-

Bill Bonner, back in Paris…

*** "I thought it was a good idea," said the woman on your editor’s right at last night’s dinner. "But I’m not sure what happens now. It’s beginning to sound like Algeria. And that didn’t end very well for us."

"I remember well my meeting with a French member of the Foreign Legion on the island of Corsica in the 1960s," writes Marc Faber in his most recent issue of the Gloom, Boom and Doom Report. "He had fought in 1954 at Dien Bien Phu in Vietnam, and served during the Algerian uprising prior to Algeria gaining independence in 1962. According to him, his regiment was relieved when they left Vietnam. Every legionnaire was looking forward to being stationed in Algeria, which they though would be like a paradise when compared to the tough campaign and eventual hellish defeat they had experienced in Vietnam.

"However, this proved to be an illusion. According to him, the Algerian war turned out to be far worse than Vietnam, because the French troops in Algeria never knew who was friend or enemy and therefore incurred tremendous casualties in continuously recurring ambushes, acts of sabotage, and raids on their camps. The problem with guerilla wars is that the enemy isn’t visible, and so, unless the local population almost unconditionally supports the occupying forces, guerrillas can easily hide among and seek support from the local population.

"Claus von Clausewitz describes in his classic work On War (first published in 1832) that any ‘attack which does not lead to peace must necessarily end up as a defense. It is thus the defense itself that weakens the attack. Far from this being idle sophistry, we consider it to the greatest disadvantage of the attack that one is eventually left in a most awkward defensive position’."

*** "Has the Japanese economy finally bounced after falling for 13 years?" we wondered yesterday.

"If we were placing our bets," we concluded, "we would much rather bet on a market that has been deflated out than one that is bubbled out to the limit of its inflationary stage. Sell New York. Buy Tokyo."

No sooner had the words escaped our mouth than heads began to nod in agreement.

"There is a strong case to be made that Japanese shares are greatly undervalued," writes Alexander Green, editor of the Oxford Club. "By many measures, Japanese stocks are among the cheapest in the world today.

"For that reason, I’m recommending a conservative way to capitalize on a rebound in Toky buy the whole market…"

More from Mr. Green on ‘buying Tokyo,’ below…