Haymaker - Friday Edition
Sector- and industry-specific market analyses to fill your weekend with ample food for thought.
Land of the (Ultimately) Rising Yen
“As a testament to how undervalued the yen is compared to the U.S. dollar, it currently sits at ¥138, which compares to its average ¥108 since 2000 (i.e., 22% cheaper than average).” -David Rosenberg, Canada’s highest-profile economist and market strategist.
This newsletter has repeatedly made the bull case for the Japanese stock market. Yet, as I’ve also written of late, it has run a lot and has become uncomfortably in-vogue, at least to a herd-shy guy like me. If you’re old enough to remember those old Merrill Lynch commercials, as I do, you’ll recall their famous “thundering herd” of bulls on display in them. Over my career, though, it’s been more akin to the “blundering herd” as investors increasingly stampede into overvalued asset classes.
Actually, it can be a pleasant experience to run with the herd for a spell, at least until a cliff is in the general vicinity. It’s nice to have all that energy and momentum on your side… to the point when it gets overdone, as all powerful bull markets do. That’s particularly the case when they morph into out-and-out bubbles.
Fortunately, in the case of Japan, it’s very early in this bull cycle, with decades of under-performance to be earned back. This 33-year lag was the price to pay for the biggest stock (and real estate) bubble in human history. That is with the possible exception of 2021 in America by a narrow group of exceptionally speculative “securities” (the theme that rhymed with “meme”).
Also, fortuitously, it’s not just Japanese stocks that are cheap and still unloved — its currency is, as well. As a result, for overseas investors, like almost everyone reading this note, a powerful potential tailwind may begin to roar for those who are willing to deploy capital into what has long been an investment wasteland.
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Before I get to the currency, I just want to mention a few of the attributes Japan’s stock market possesses (note, its bond market is a very different story, as I will soon cover). First of all, Japanese households are extremely underinvested in domestic equities. Collectively, they have about 10% of their assets allocated to their homegrown stocks, versus 20% in Europe and 40% in the U.S.
Next, Japanese corporations are exceedingly cash-rich due to years of ultra-conservative balance-sheet management. Cash as a percentage of overall assets is about 25% in Japan as opposed to about half that with American companies. This is despite that the mega-cap U.S. tech names are brimming with liquidity.
Moreover, Japanese corporate chieftains have learned from their Stateside counterparts and are now deploying some of their vast reserves into share buybacks and dividends. In fact, the combination of those for its TOPIX-listed companies is essentially on a par with the S&P 500. Unquestionably, Japan has become a much more shareholder-friendly country.
As I noted recently, valuations are also most undemanding. The P/E ratio based on estimated earnings for the next 12 months is around 15, as compared to 19 in the U.S. Further, the latter is based on highly optimistic earnings projections. That’s much less likely to be the case in Japan where expectations are much more conservative. As you can see below, Japan has been out-legging even a red-hot S&P 500 this year with its TOPIX (white line) having produced a total return (with dividends) of 22.8% vs 15.8% for the S&P.
(Click chart to expand)
To be fair, there is a notable negative with the Japanese stock market. That would be its central bank, which has been a massive buyer of its stocks over the years. Following in the reckless footsteps of its global peers, it has done so with magic-wand money. The Fed is not the only central bank with a Magical Money Machine. Recently, the Bank of Japan owned roughly 70% of its nation’s equity-based ETFs, or about 7% of its publicly traded shares. On the plus side, at least it accumulated most of these at depressed prices. My expectation is that there will be a lengthy reallocation process where the BOJ gradually disposes of its holding to the stock-light household sector. Mrs. Watanabe, as the retail Japanese investor is often known (women are active traders over there, a seemingly incongruous situation in that male-dominated society), is sitting on an enormous cache of cash… and bonds, too. In other words, she has plenty of firepower with which to buy stocks. Japanese dividends are now higher than both the yield on bonds and cash, giving her more impetus to do so.
Now, let’s talk yen. As you can see in the following chart, it is exceptionally cheap on a real effective exchange rate basis, adjusted for inflation. This is even the case when including emerging market (EM) currencies — like the Brazilian real and the Mexican peso — which tend to trade inexpensively. (The red line below includes that class of currencies.)
This is also true when isolating the yen relative to the U.S. dollar. When one considers Japan typically runs hefty trade surpluses, in contrast to America’s chronic current account deficits, this is even more surprising. (PPP stands for Purchasing Power Parity; the orange line displays Japan’s positive trade balance which only once touched zero, back in 2014.) According to one source, the yen is so depressed presently that Japan’s labor costs are now lower than China’s!
Related to this, Japan is among the world’s largest creditor countries. This is again in glaring juxtaposition to the U.S. which is deeply in hock to the rest of the planet. In fact, Japan is the largest holder of U.S. Treasury securities (USTs), nosing out China. Japan’s $1.1 trillion of USTs is more than double the UK, the nation in third place in the Treasury sweepstakes.
But, as we all know, cheap assets can stay that way for a long time in the absence of a catalyst. My belief is that just such a trigger is poised to be pulled…
For many years, the Bank of Japan has engaged in yield curve control (YCC). It has held the interest rate on 10-year Japanese government bonds (JGBs) at ½% or lower. Yet, like in most countries, inflation has been surging. Mind you, in a country that has had recurring bouts of deflation, it’s not at American-type levels, but the latest CPI readings have been running a bit over 3%. For them, that almost feels like hyperinflation; regardless, it’s a lot higher than ½%. Consequently, Japan has deeply negative real yields. Pressure is now mounting on the BOJ to let rates rise, potentially a lot. In my view, the days of YCC in Japan are approaching their expiration date.
If that were to occur, the yen should rally hard. Based on its extraordinarily undervalued present status, the price surge could be jaw-dropping. This is despite that Japan’s government is heavily indebted, unlike its private sector. However, nearly all of that is owed internally, once again in stark contrast to America.
There are several ETFs that allow U.S. investors to diversify out of the creaky greenback into the yen. The version that provides two-times leverage on the yen’s price swings produces a K1, though of a simplified variety. At least one ETF is unleveraged, so it will fairly closely track the yen’s movements and it doesn’t generate a K1. It’s fair to note there is some leakage over time due to embedded friction costs. This is even more the case with the leveraged version. Thus, when it has a major up-move, doing some profit-taking is even more important than normal. Volatility increases the friction drag, but if you’re willing to sell into strength and rebuy on weakness, you can make those fluctuations work in your favor. Hopefully, I’ll be able to help you in that regard in the months and years to come. (Full disclosure: I am personally long yen futures contracts while also short Japanese government bonds.)
Champions
Japanese yen
Gold & gold mining stocks
Uranium
Farm machinery stocks
Select financial stocks
Oil and gas producer equities (both domestic and international)
U.S. Oil Field Services companies
S. Korean stock market
Copper-producing stocks
For income:
Certain fixed-to-floating rate preferred stocks
Select LNG shipping companies
Emerging Market debt closed-end funds
Mortgage REITs
ETFs of government guaranteed mortgage-backed securities
BB-rated energy producer bonds due in five to ten years
Select energy mineral rights trusts
BB-rated intermediate term bonds from companies on positive credit watch
Contender Picks
With yields up sharply on thee-to-five-year U.S. Treasury notes (USTs), these now deserve to be on a watch-list for an upgrade to buy. (In fact, doing some buying right now is reasonable.) The Fed’s “hawkish pause”, as Wednesday’s decision has been widely characterized, reinforces the bull case for this part of the Treasury yield curve, in my view.
As you may have seen or heard, the majority of participants on the Fed’s Open Market Committee are leaning toward two more rate hikes. If that target is actually hit, this would bring the key overnight rate to close to 6%. At that point, the odds become even higher of a sharp rise in unemployment, triggering an actual recession. As it is, an earnings recession is fait accompli and an industrial/manufacturing downturn also appears increasingly probable. (See the acute weakness in trucking and railroad shipments, as well as the softness in cardboard prices.)
Once this evidence becomes overwhelming — even to the perennially sunny talking heads on CNBC — the Fed is likely to shift into easing mode. When it does, the rate cuts could/should be fast and furious. That will almost certainly be beneficial to short-to-intermediate Treasurys. However, I continue to worry that the longer end may come under upward yield (and downward price) pressure due to the shortage of buyers and a torrent of new supply, in addition to trillions of maturing government debt. The realization that the only way for the U.S. government to repay its debt is with printing-press money should also finally dawn on the investment community at large, both domestically and internationally. Accordingly, a buyers’ strike could plausibly hit longer Treasurys in the second half of this year.
Short-intermediate Treasurys (i.e., three-to-five year maturities)
Japanese stock market
Top-tier midstream companies (energy infrastructure such as pipelines)
European banks
U.S. GARP (Growth At A Reasonable Price) stocks
Telecommunications equipment stocks
Swiss francs
Singaporean stock market
Intermediate Treasury bonds
Small cap value
Mid cap value
Select large gap growth stocks
Utility stocks
Down for the Count
Based on the management circus at one of the most (in)famous meme stocks, its recent rally is truly inexplicable, even considering the often-irrational price surges in this strange slice of the equity market. For venturesome types, put buying may be an appropriate though, obviously, high-risk play. Also, on the bullish side, the executive chairman recently purchased $10 million of additional shares.
Meme stocks (especially those that have soared lately on debatably bullish news)
The semiconductor ETF
Junk Bonds (of the lower-rated variety)
Homebuilders stocks
Financial companies that have escalating bank run risks
Electric Vehicle (EV) stocks
The semiconductor ETF
Bonds where the relevant common stock has broken multi-year support.
Long-term Treasury bonds yielding sub-4%
Profitless tech companies (especially if they have risen significantly recently)
Small cap growth
Mid cap growth
IMPORTANT DISCLOSURES
This material has been distributed solely for informational and educational purposes only and is not a solicitation or an offer to buy any security or to participate in any trading strategy. All material presented is compiled from sources believed to be reliable, but accuracy, adequacy, or completeness cannot be guaranteed, and David Hay makes no representation as to its accuracy, adequacy, or completeness.
The information herein is based on David Hay’s beliefs, as well as certain assumptions regarding future events based on information available to David Hay on a formal and informal basis as of the date of this publication. The material may include projections or other forward-looking statements regarding future events, targets or expectations. Past performance is no guarantee of future results. There is no guarantee that any opinions, forecasts, projections, risk assumptions, or commentary discussed herein will be realized or that an investment strategy will be successful. Actual experience may not reflect all of these opinions, forecasts, projections, risk assumptions, or commentary.
David Hay shall have no responsibility for: (i) determining that any opinion, forecast, projection, risk assumption, or commentary discussed herein is suitable for any particular reader; (ii) monitoring whether any opinion, forecast, projection, risk assumption, or commentary discussed herein continues to be suitable for any reader; or (iii) tailoring any opinion, forecast, projection, risk assumption, or commentary discussed herein to any particular reader’s investment objectives, guidelines, or restrictions. Receipt of this material does not, by itself, imply that David Hay has an advisory agreement, oral or otherwise, with any reader.
David Hay serves on the Investment Committee in his capacity as Co-Chief Investment Officer of Evergreen Gavekal (“Evergreen”), registered with the Securities and Exchange Commission as an investment adviser under the Investment Advisers Act of 1940. The registration of Evergreen in no way implies a certain level of skill or expertise or that the SEC has endorsed the firm or David Hay. Investment decisions for Evergreen clients are made by the Evergreen Investment Committee. Please note that while David Hay co-manages the investment program on behalf of Evergreen clients, this publication is not affiliated with Evergreen and do not necessarily reflect the views of the Investment Committee. The information herein reflects the personal views of David Hay as a seasoned investor in the financial markets and any recommendations noted may be materially different than the investment strategies that Evergreen manages on behalf of, or recommends to, its clients.
Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this material, will be profitable, equal any corresponding indicated performance level(s), or be suitable for your portfolio. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Investors should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.
Is there an efficient, but convenient way to short JGB available in the US? I did some quick searching, but didn't find anything obvious.