An almighty debate is raging across one of the world's biggest financial markets. In the one camp, enthusiastic foreigners are pouring money into Japan, sensing that this benighted market is at last breaking free of 15 years of deflation. They foresee an end to the world's longest-running bear market and a return to rising land prices, healthy profit margins and resurgent bank lending. In the other corner are the Japanese themselves, more than once bitten by this market and so more than twice shy. They see this as merely the fourth bear-market rally in an unending structural decline and cite the appearance of many of the traditional warning signs of a cyclical peak in economic activity.
With two such diametrically opposed views battling it out, the volume of shares traded on the Tokyo Stock Exchange has skyrocketed (the Japanese are all selling and the foreigners are all buying) - on some days there has been more trading than there was back at the peak of the bubble in the late 1980s. Regular readers will know that I come down on the side of the foreigners here. Back in August, I argued that the Japanese stockmarket was about to embark on a significant new upswing and that the bear market was, effectively, finally over. Since then, the Topix index has gained 12.7%.
Stocks and bonds
This makes sense. Profit margins in Japan have improved to such a degree that the market's once famously expensive stocks now trade on a prospective p/e of just 16 times, no different to the rest of the world's major markets. Indeed, profit margins, having been below 2% just six years ago, are now well over 5%, and are the highest they've been in more than 45 years. They are also rising independently of the rate of sales growth.
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More significantly, with interest rates and government bond yields so low, equities look like good value. The benchmark ten-year Japanese Government Bond (JGB) yields just 1.5%. Stocks arguably yield' more than four times as much. The earnings yield is just the inverse of the p/e, so Tokyo's p/e of 16 times implies a yield (assuming all profits were paid out) of 6.25%. This means stocks could double and then double again before they traded on a par with bonds. The earnings yield for many Anglo-Saxon markets usually ranges between being on a par with government bond yields to yielding half what bonds do (stocks usually yield less than bonds due to their capacity for capital growth), so you can see why foreign investors are impressed.
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Property and reits
Just as racy an argument holds for property. When Japan's bubble burst in 1990, the banking sector was left holding increasingly worthless property portfolios as collateral for speculative loans gone bad. A classic credit crunch has ensued. Banks still can't lend more money until they've realised these losses and they can't do that until they've sold these property portfolios off. However, because the banks were all in the same boat, few prospective buyers have been able to raise a mortgage to buy property, so the banks have been stuck with it. Catch-22.
But after 14 years of decline, Japanese property prices are now so low that commercial property can pay gross yields of 7%-8%. Residential yields are even higher. The new Japanese Reits (real estate investment trusts) are regularly stuffing their books with properties that return gross yields of as much as 12%. Since their borrowing costs are usually no more than 1.75%, even net yields can be more than four times the cost of debt. Reits' borrowings are not allowed to exceed 60% of assets, so they can't buy everything they want. If they could, Japan's property slump might have been over already. Still, it's getting there: there is talk that the Yamato Seimei building, next to the prestigious Imperial Hotel and opposite the Emperor's Palace, has just been bought by a Reit for a price that offers an implicit residual rental yield of just below 6%, which implies that prices in ultra-prime Tokyo have risen significantly.
The view from Tokyo
So why are the Japanese themselves so unwilling to believe? There's a well-known saying in Japan that the nail that stands out will be hammered down, and certainly, those who stood up and bought into any of the previous three market rallies, at this late stage in the cycle, got well and truly hammered down.
Once again, the argument goes, the warning signs are flashing red. Firstly, say the bears, the yen has been falling steadily for several months now. Whenever Japan has done well(ish) in the last decade and a half, it has been when the American economy has boomed and sucked in even more Japanese imports. More Japanese products sold into the US means more yen purchased to buy them. So a falling yen is taken as a sign that US demand is faltering and there are increasing signs that the American consumer is starting to struggle. So there is a valid worry here. Having said that, China's economic growth appears to be reaccelerating, something that could compensate for any fall off from the US.
Also, in Japan the inventory to shipments ratio is already rising. This is a bad sign, as it implies that not all Japan's goods are finding a market. And if too much inventory piles up in the warehouses, production will have to be cut back and the economy will slow again. Sure enough, industrial production has already ceased growing and history suggests it will shortly lead capital expenditure - which has been surprisingly robust - back down towards negative territory too.
The bull defence
But, counter the foreign bulls, that is not to say that all cyclical signs are negative. The leading indicators point to a recovery in industrial production within six months, potentially reversing most of the worrying signs the Japanese are so focused on. More significantly, consumer confidence, driven by better income metrics and an improvement in the employment environment, is back at its highest for a decade and a half. That augurs well for further stockmarket gains, which in turn would feed back positively into the leading indicators and boost the wealth effect too. Consumer confidence (now back up at 1991 levels) feeds into the consumption component of GDP, a key determinant of top-line revenue growth. For stocks, top-line growth would boost an already cash-rich and profitable corporate sector.
Still, the Japanese aren't convinced. And they may feel vindicated over the next few months. We're about to enter Japan's worst quarter (relative to the rest of the world) of the year. Almost every year, Japan's relative performance hits its nadir around New Year. Many hedge funds have December year-ends, so there's a temptation to lock-in profit (and performance fees) by selling ahead of book-closing. So we may see a correction in the market before Christmas.
The Japanese have another reason for showing antipathy towards their market, though: it hasn't proved itself to them yet. The benchmark Topix index fell 85% relative to stocks in the rest of the world between 1990 and 1998. At its nadir, it fell to about 10% of its peak compared to the rest of the world, and it's still just 14% of that peak today. But it's been flat relative to the world for the last eight years. That means the absolute gains since the April 2003 low have just reflected a rise in line with a global phenomenon, rather then any Japanese-specific recovery. Perhaps this explains why the domestic institutions continue to sell (they've dumped over 10trn of stock over the last couple of years) and why the big life companies still have twice the weighting of foreign securities in their funds as domestic equities. After all, why buy Japanese stocks until they have proved, at least once, that they can outperform the alternatives?
For the Topix to break the selling habits of the domestics, it has to prove it can outperform. When that happens, which I think it will, the tide should well and truly turn. Whatever the next quarter is like, whether hedge funds sell it down or momentum carries it higher, a real surge in stock prices in Japan relative to the world will come in the first quarter of next year. If you're going to gear up to this market, you'll want to do it some time before then.
