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The Running Of The Japan Bears

Courtesy of ZeroHedge. View original post here.

Authored by Nick Schmitz via Verdad Capital

We’ve done a National Geographic–style deep dive into the world of the Japan bears, reading the scare stories about demographic decline, old people dying alone, underrepresentation of minorities on corporate boards, and other anecdotal “evidence” of stagnant economic prospects. We tried to find the best examples of Japan bearishness: the scariest pieces of evidence we could find, stuff that portrays the world’s third largest economy as a zombie death trap for equity investors.

The two most established predictors of future equity returns are value and momentum. Academic research says buy stocks that are cheap and improving, at the fulcrum when other investors are starting to recognize that they are undervalued.

We believe Japanese equities today are at the fulcrum. Japan is the cheapest developed market in the world, and sentiment is shifting as other investors recognize the undervaluation. Japan bears are on the run.

Renowned investor and manager of the Yale endowment, David Swensen, recently highlighted his newfound enthusiasm for Japanese markets: “There are some very interesting things going in Japan, one of the places I’m most optimistic about. It seems like capitalism might actually be taking root, making progress there.”

Commentators, economists, and journalists have begun voicing an unfamiliar sentiment on Japan, arguing that it is a turnaround story, with Abenomics showing signs of paying off with attractive financial markets.

Perhaps most colorfully, Gluskin Sheff's chief economist, David Rosenberg, recently noted, “The one part of the world which looks very good to me right now, a great turnaround story that’s under-owned, is Japan… I think even a child could see that the 30-year secular downtrend has been broken over the course of the past couple of months… Japan is probably the most under-owned stock market on the planet from a global portfolio manager perspective.”

Rosenberg may be right. The pessimistic litanies of the Japan bears have scared most international investors away from the world’s third largest economy, leaving global asset allocators significantly underweight Japan.

Figure 1: Global Asset Allocators Significantly Underweight Japan (Z-Score in Standard Deviations from Mean)

Source: Wellington Management, November 2017. Data as of October 2017. Positions shown reflect positioning of funds in the EPFR Global universe versus their respective benchmarks.

However, winter seems to have arrived for the Japan bears, and evidence is mounting that their severe pessimism about Japan has been overwrought. Investors are starting to ask the obvious questions: “What could justify Japan trading at 7x EBITDA when the US trades at 13x EBITDA? Why is Japan 40% cheaper per dollar of earnings or dollar of book value than the US market?”

We’ve done a National Geographic–style deep dive into the world of the Japan bears, reading the scare stories about demographic decline, old people dying alone, underrepresentation of minorities on corporate boards, and other anecdotal “evidence” of stagnant economic prospects. We tried to find the best examples of Japan bearishness: the scariest pieces of evidence we could find, stuff that portrays the world’s third largest economy as a zombie death trap for equity investors.

Bear Argument #1: Japan’s aging demographic will cause GDP stagnation.

Start talking to a Japan bear and the first growls you will hear will be about Japan’s aging demographics that will drag on GDP growth and create a poor environment in which to invest in domestic stocks.

They may be right about the demographics, and right about the GDP growth, but the problem with the argument is that there’s no empirical evidence to link GDP growth and equity returns. Vanguard’s review of 42 years of GDP growth and international equity returns found almost no correlation between country growth and equity returns.

Figure 2: Comparison of Annualized Real GDP Growth and Real Stock Returns across Countries (1970-2012)

Source: Vanguard, September 2013

The best predictive indicators for equity returns are not the number of elderly dying alone, demographics, or even GDP growth but rather the two definitive findings from academic literature: value and momentum.

Bear Argument #2: There is a lending crisis in Japan: if demographics don’t kill Japan, debt will.

Japan bears argue that the country is facing a lending crisis and that small business lending practices have been at an “imminent tipping point” for the past 15 years. Below is the Grand Prize winner for flimsy bear evidence: apparently three pictures of small retail stores are a sure sign of a Japanese lending crisis. We have yet to verify these were not taken in West Virginia.

Figure 3: “Evidence” of Japan’s Lending Crisis from a Prominent Japan Bear

Source: Google Images

We were worried that there might be a looming corporate macro debt crisis in Japan, so we compared the aggregate corporate debt level in Japan with that of the United States to see if Japanese lending was at a tipping point. One country tripled their corporate lending this millennium while another cut theirs nearly in half. See if you can guess which is which.

Figure 4. Corporate Ex-Financial Debt (Japan vs US)

Source: Federal Reserve Bank of St. Louis

Japan certainly has its anomalies, with lenient corporate lending standards, and there is an element of truth in the small business lending statistics often cited. But if systemic collapse predicated on unsustainable corporate lending is your primary concern, it’s not 100% clear Japan should be the primary target of your bearish bets.

Bear Argument #3: Japanese equity markets are one big value trap.

Bears have argued that the TOPIX and the Nikkei have been flat for decades and that there is an “iron coffin lid” that caps the amount of equity appreciation in the country permanently. No one can make any money in Japan because of the iron law of the iron coffin lid.

Figure 5: Evidence of Japan’s “Iron Coffin Lid” from a Prominent Japan Bear

McConaghy: "what is referred to by some in the Japan markets as the 'Iron Coffin Lid'…"

We were worried that we had missed a class on “Iron Coffin Lid” charting theory in business school, so we did some research. We found no published literature on Iron Coffin Lids, apart from this World of Warcraft level 174 enchanted Paladin’s shield, which provides a rather unimpressive +178 armor and +14 strength rating for online gamers.

Bulls and Bears aside, we have no idea whether Japan will grow at zero or two percent over the next decade. We don’t believe anyone does. We were, however, pleased to see Cliff Asness’s recent study showing that a Japanese deep-value approach would have outperformed significantly on a risk-adjusted basis during the “lost decades,” when Japanese equities endured the most intense consensus pessimism about a developed market in modern times.

Figure 6: Deep Value Portfolio Performance

Source: Cliff Asness et al., “Deep Value,” November, 2017.

We believe the under-allocation to Japanese equities is not warranted by the fundamentals. With fundamentals still cheap and the sentiments of our expert commentators and forecasters shifting over the summer and fall, we wouldn’t be surprised to see significant fund flows into the Tokyo Stock Exchange as asset allocators get around to rebalancing in January away from what we believe to be the overpriced and over-exposed, back towards the underpriced and under-exposed.


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