097Triangulate Japan

posted on May 1st, 2008

What’s up or rather down with Japan? Here is why the Japanese market is drifting and why the bull story is still intact.

After a great 2005, the Japanese market as represented by the Nikkei 225 is down 3.3%. Relative to the global equity sell off, this is not bad but the weakness has soured interest in the Japan story.

At the World Money Show in January 2006, I anticipated this weakness since the great gains in 2005 were fueled by foreign investors and not the Japanese. In fact, Japanese institutional investors were net sellers in 2005 and Japanese retail investors only nibbled at the edges.

As 2006 opened, the majority of foreign money managers were overweight Japan which is saying a lot since Japan represents 65% of the Asia MSCI index. As these foreign flows of capital have slowed, Japanese investors have stepped up their investing in the Japanese market but at a slower pace. Therefore, the overall market is going sideways. Think of a bathtub with more water going down the drain then coming in at the spigot.

At some point later this year, I believe that overseas investors will come back searching for quality markets like Japan, Japanese investors will pick up their pace of buying plus M&A activity will also drive Japan’s markets. This triangle of capital flows will re-ignite the Japanese bull market.

New corporate law introduced just last month will make it easier for foreign firms to convince Japanese shareholders that a merger with a foreign firm is in their best interest. Also, starting next May, foreign firms will be able to purchase Japanese shares in a M&A transaction with shares rather than cash using a 100% owned Japanese subsidiary. This is referred to as a triangular merger. M&A activity in 2005 was already strong with 2,713 transactions setting a record. The spinoffs and restructurings will also increase.

Japanese corporate activity is robust with machine orders coming in today above optimistic expectations. Banks are lending and capital formation is building momentum. In February, bank lending showed positive growth for the first time in eight years.

The Japanese are also managing low-cost competition from countries like China better than America. While moving low-end manufacturing oversea, Japanese companies are holding on for dear life to the more profitable higher-end products and protecting R&D by keeping it at home.

Consumer spending which makes up 55% of GDP needs to quicken and that is why the behavior of the Japanese consumer and investor needs to watched like a hawk. Getting the first small and inevitable interest rate hike out of the way would also be a major plus for the market.

Keep most of your powder dry for now and if the Nikkei 225 index falls from the current 14,750 to below 14,000, I would see it as the time to begin building a significant position in the Japan iShare (EWJ).
If you choose to follow our ETF plus one strategy, I would recommend the financial services and securities firm Nomura (NMR) which is down 5.7% this year. At $18 a share, it is off its 52 week peek of $24 and will benefit from increased share trading and M&A activity.

Japan is back and has a rightful place in your global ETF portfolio but stay underweight the indexes and pick your timing carefully.

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