Japan rallies belie downward trend and risk of ‘value traps’

On December 29, 1989, Japan’s Topix stockmarket index hit its peak. Since then, its annual direction has been unpredictable, but in aggregate it has gone only one way - down.

Various reasons have been given for its decline. According to the Barclays Equity-Gilt study, the Japanese equity cohort, or the age group, which tends to invest the most in stocks or have the most invested on its behalf, also peaked in 1989.

With the population ageing, heading closer to retirement and generally becoming more risk-averse, domestic financial institutions sold stocks and gravitated towards bonds. After Japan’s banking crisis, its institutions increasingly favoured government over corporate debt, helping to build the gigantic state debt mountain that persists today.

Another factor is the country’s deflationary psychology. The Japanese property market peaked at about the same time as the stockmarket, sending prices downwards over the next two decades. Consumer prices also declined, making it more difficult for companies to push up earnings even as prices that investors were prepared to pay for those earnings declined.

But despite the country’s dire long-term characteristics, investors face an enormous quandary with Japan. As recently as 2009 and 2010, the stockmarket has previously experienced massive rallies, which have so far subsided into the usual bear market. (article continues below)

As Japan is still one of the world’s largest three economies and constitutes a reasonable portion of global stockmarket indices, managers still feel obliged to have an opinion on where the market is heading.

Although completely unconstrained managers can avoid the country altogether, managers and clients who do not want excessive short-term volatility compared with a benchmark have to bear in mind that a sudden rally in Japan could cause exactly that.

David Hambidge, an investment director for pooled funds at Premier Asset Management, describes Japan as a potential “value trap”, or a stockmarket investors buy because it has declined to such an extent that it looks irresistibly cheap.

Hambidge says this attitude towards Japan applies particularly when other asset classes look extremely expensive. The solid record of buying bargains then looks particularly alluring, including at present, when investors are complaining that bonds and emerging markets are both experiencing bubble-like inflows.

However, given the dilemmas involved, some managers prefer not to make big calls on the market and heavily overweight or underweight it compared with the index.

Rob Burdett, a co-head of multi-manager at Thames River Capital, the F&C subsidiary, tries to find Japan managers who can deliver consistent outperformance relative to their index, rather than making big calls on whether Japan will outperform globally.

The problem is that some of the best performing managers base their stock picks and fund management on macro calls about where the country is heading. Chris Taylor, for instance, who manages the Neptune Japan Opportunities fund, has said Japan’s multinationals look much healthier than the domestic economy, which is likely to continue its downward spiral.

He says the best way of making money in the long term is by buying big Japanese exporters and hedging to benefit from a weakening in the Japanese currency, which makes exporters’ goods more competitive and overseas earnings more lucrative.

However, as Burdett points out, there are short-term risks to this approach. In particular, the strengthening of the yen made Japanese markets outperform in 2008 and 2010 in foreign currency terms, despite weakness in stocks in 2008 in particular. Second, Taylor’s high-conviction approach means he can outperform strongly in one year and underperform strongly the next, as happened in 2009 and 2010.

In the country that has flattered to deceive for two decades, forecasting such scenarios has proved notoriously difficult.