Japanese Small Caps
January 31, 2011
Market Vane Indicator Market Technicals Market Trading Volume Yen Interest Rates Best Sector 1 Mo. Worst Sector 1 Mo. Economic Momentum
Closing Values
Direction Bullish
Indicator Topix
Week Close 919.69
Prev. Week 910.85
Bullish
NK225
10,360.34
10,274.52
Weakening
TSE 2
2,304.10
2,254.74
JASDAQ
54.26
53.24
JGB Yield (%)
1.210
1.210
Rubber Products
Yen-Dollar
82.64
82.94
Waning
EAFE ETF
60.27
58.92
Rising Real Estate
Sources: Tokyo Stock Exchange, Nikkei Financial, Yahoo.com
Japanese Small Caps Fund manager surveys in January show shift toward equities versus bonds, and a significant improvement in desired portfolio weightings for U.S. and Japanese equities has happened over the past month. On the other hand, investor sentiment toward emerging markets and commodities has visibly cooled. In 2010, small caps led the recovery in equity markets. But small cap performance in the U.S. has begun to lag, which is keeping with the historical pattern that small cap and large cap performance has roughly been the same in the second year following a recession. Basically, small cap outperformance is strongly tied to market direction. In other words, small-caps are pretty well correlated to large-caps but are about 30% more volatile. The small cap movement in Japan however is completely out of sync with the U.S. experience. Japan small caps peaked in Q1 2006, or over a year before the Nikkei 225 peaked. Small caps continued to lag until October 2008, because, a) Japan’s recovery much less clear, b) because of the yen’s surge to 15-year highs and c) because individual investors, which account for over 70% of t trading in small caps, were avoiding stocks. Further, the relative performance of Japanese small caps was completely eclipsed by dramatic recoveries in other Asian markets, including Indonesia, India, and Thailand. As the Asian markets consolidate, however, Japanese small caps---particularly small cap value—are visibly outperforming the Nikkei 225 and Topix. Further, they look poised to break out of the trading channel they have been entrapped in since 2009. Thus our preference is for Japanese small cap ETFs over Nikkei 225 constituents to maximize the relative performance of Japanese equities over Asian market competitors in the first half of 2011. The only exception to this view is the TSE Mothers, which continues to underperform. We do not, however, recommend shifting funds out of U.S. equities into Japanese equities, because U.S. equities (S&P 500 and NASDAQ) continue to outperform Japanese equities. Rather, we would be allocating funds away from the emerging and Asian markets in favor of Japan.
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TJI MARKET LETTER 11.01.31
TJI Model Portfolios
Sources: Tokyo Stock Exchange, Yahoo Japan, Yahoo
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TJI MARKET LETTER 11.01.31
Global Investor Sentiment Has Visibly Improved for the Developed Markets, Waned for Emerging Markets and Commodities The January 2011 BofA Merrill Lynch survey of global fund managers indicates that growing confidence in the economic recovery has raised global investor appetite for equities to its highest level in 3 1/2 years. A net 55% of asset allocators say that they are now overweight global equities, the highest reading since July 2007, and significantly higher than the net 40% overweight in December. At the same time, a net 54% are underweight bonds. Sentiment has significantly improved for U.S. equities, with 27% now saying they are overweight, which is the highest reading since November 2008 and significantly higher than the December 16%. Further, a net 15% would like to overweight U.S. equities more than any other region. Japan has also benefited, as global investors have moved overweight Japanese equities for the first time since May 2010 and for only the fifth month in 3 1/2 years. A net 5% of global fund managers are now overweight Japanese equities, compared with a net 29% underweight in November. Global emerging market sentiment remains high but continues to decline, with a net 43% saying they are overweight GEM equities, versus a net 56% two months ago. A net 20% are still overweight GEM equities more than any other region. Sentiment regarding commodities has also deteriorated, with a net 16% saying they are overweight, down six percentage points from the last month. This fall comes despite growing expectations of higher inflation. Basically, emerging markets can also be considered small cap stocks. Leveraging the Best Alpha From Japan: Small Caps Both academics and market practioners have well-documented the tendency of small cap stocks to outperform larger cap stocks in periods when the economy is emerging from recession. Comparing the S&P 500 large caps and S&P 600 small caps indexes over the past five recessions, we find that small caps rebounded on average 25.7% compared with 23.6% versus their large-cap counterparts in the three months between the trough and the end of the recession. Further, small caps vastly outperformed large caps--rising 26.8% compared with only 10.1%--in the first 12 months following the end of the recession. This small cap outperformance is at the core of the Fama-French Three-Factor Model, an economic theory used to describe market behavior based on Price/Book Value (P/B). So why does the research show small cap stocks tend to outperform large cap stocks over the long term? The simple answer is that small cap stocks are riskier, i.e., they are more volatile and have a higher Beta. Small-cap outperformance is strongly tied to market direction, i.e.,
small caps have consistently out-performed in bull markets and underperformed in bear markets.
It is therefore much more important for small cap investors where your entry point is. The two charts below show the pitfalls of a simple “small-cap stocks outperform” dogma. Over the 10 year period to end-2009, the surprise was that mid-caps, not small caps, outperformed. Further, despite all the supposed benefits of international diversification, the MSCI EAFE index has only just matched the S&P 500 large caps, but have lagged the midas well as small-caps.
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TJI MARKET LETTER 11.01.31
Between end 2001 and end 2010, the S&P 500 was basically flat, while performance of the S&P mid-cap and the S&P small-cap was virtually the same. Further, the red line in the chart below right shows how small caps perform in weak markets—i.e., badly. Mid Caps Actually Lead
Source: Marketsci Blog
Source: AXA Equitable, Japan Investor.com
Over the past year (see table below), small caps were outperforming in virtually every equity market except Japan in displaying the typical historical pattern of outperforming in the early stages of economic recovery. In 2011, however, small-cap YTD performance has lagged, as the U.S. consensus going into 2011 is that its time for lagging larger cap companies to outperform. This view is based on historical experience and actual market data YTD. In the second year following the recession, small caps and large caps have historically performed largely in line with each other, with small caps rising 7.2% on average versus 6.4% for the large caps, and they begin to lag from year three. Small Caps Outperformed in 2009, Now Lag
Source: BigCharts.com
Source: MSCI/Barra
Switching From Emerging Asia into Japanese Equities The move in Japanese small caps is out-of-sync with the U.S. Small caps in Japan peaked well before the overall peak in Japanese stock prices in 2007. The big peak for small caps in Japan was in early 2006, midway in the Junichi Koizumi-instigated clean-up of Japanese bank balance sheets, and the relatively strong GDP growth Japan enjoyed during the Koizumi reform years. In January 2006, the JASDAQ and small-cap Japanese stocks in general were hit hard by the Livedoor scandal, when corporate fraud resulted in large numbers of investors holding paper that was virtually value-less.
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TJI MARKET LETTER 11.01.31
The scandal uncovered a lot of loose accounting and auditor exceptions in companies listed on the Mothers and other junior exchanges. The 2009 recovery in Japan, while generally trending with overseas equity markets, was much less clear because of the yen’s surge to 15-year highs and a double dip in Japan’s economy in the last quarter of 2010 as domestic demand stimulus measures wore off. Further, the relative performance of Japanese small caps was completely eclipsed by dramatic recoveries in other Asian markets, including Indonesia, India, and Thailand. Japan Eclipsed in 2009, 2010 by Other Asia
But Inflation Concerns Now Stunt Asia Rally
Source: BigCharts.com. EWJ = Japan, INP =India, EWZ =Brazil, RBL = Russia
Source: Nikkei Astra
Going into 2011, however, hot emerging markets like China, Brazil and India are being
hobbled by central bank monetary tightening to get ahead of growing inflationary pressures, and once-hot markets like India are now testing medium-term downside resistance. Foreign
investors as well as domestic individual investors are now looking to Japan as the contrarian call (dark horse) for 2011 and foreign investors are restoring Japan weightings at least to a neutral position in their global portfolios. As individual investors recently account for over 80% of trading on the JASDAQ and well over 70% for all small caps, it is the foreign investors who have to watch what individual investors are doing.
The CityUK estimates that global assets under management rebounded 14% in 2009 to
just under USD80 trillion, the bulk of which are pension funds (USD28 trillion), mutual funds (USD22.9 trillion) and insurance funds (USD20.4 trillion). Global asset allocation for the top 500 as measured by Pension & Investments/Tower Watson’s World 500 as of 2008 shows these institutions structurally overweight the U.S. and Europe, underweight Japan and underweight emerging/other markets vis-à-vis the market cap share of these markets. However, as investors were piling into emerging markets in 2009 as they chased extremely strong performance, they probably have as much exposure to Asia/emerging markets as they want right now. Global Assets Under Management
Asset Allocation of the World’s Largest
www.TheCityUK.com
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www.TheCityUK.com
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TJI MARKET LETTER 11.01.31
Not All Japanese Small Cap Indices Created Equal However, differences in index construction and constituents show that all Japan small cap indices are not created equal. While all the Japan small cap indices are still below levels in 2007, the MSCI Japan Small Cap Value and MSCI Japan Small Cap Indices are outperforming by a wide margin, while the TSE Mothers index has performed especially poorly. MSCI Small Cap Indices Outperform
Performance of Japan Small Cap ETFs
Source: BigCharts.com
Source: Nikkei Amsus
The long bear market in Japan has taken its toll on sell-side research coverage, especially for smaller-cap issues. Consequently, overseas investors have trouble finding research or company disclosures in English for these companies and moreover, can get caught in individual names because of thin liquidity. For example, foreign hedge funds in 2006 were shorting larger-cap Japanese stocks and going long smaller-cap Japanese stocks that were being bought by individual Japanese investors. However, the Livedoor scandal sent individual investors fleeing from small caps, while the larger cap stocks actually outperformed—leaving the foreign hedge funds high-and-dry trying to liquidate individual positions in illiquid small cap stocks. It is therefore easier and less risky to invest through baskets of small-cap stocks, such as US-listed ETFs like JSC (SPDR Russel/Nomura Japan Small Caps), DFJ (Wisdom Tree Japan Small Cap Dividend) or SCJ (iShares MSCI Japan Small Cap Index). Unlike the static Tokyo Mothers index which includes a lot of chafe with the wheat, the constituents of these funds are regularly reviewed to weed out the weaker factors. The above chart shows that the performance of these ETFs is virtually the same, although SCJ has underperformed from time to time because of a higher weight in financials (currently at 17% versus 14% and 11% respectively for JSC and DFJ). Further, these indices
are breaking out to the upside, above interim highs in 2009 and 2010—which implies a run at 2007 highs, as other global markets also claw their way back to 2007, or pre-crisis, highs. But There Is Still Better Alpha Available in the US However, as everyone is aware, Japan still has some issues that will work to limit market upside. The first is that domestic investors have become structural net sellers of equities, which means they continue to basically be net sellers into foreign buying. This is a significant difference than the historical pattern, when foreign buying would elicit “coat tail” buying by Subscribe or renew at www.japaninvestor.com
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TJI MARKET LETTER 11.01.31
domestic investors. The second is the long-term drag from government debt that on a net basis is now over 100% of GDP. This is forcing the government to seriously consider a significant consumption tax hike and other austerity measures that could very well keep domestic demand below potential. The third is that much of the price formation in small cap stocks comes from individual investor trading, and thus individual investor participation is key to a sustainable rally. Thus as Japan’s economy pulls out of its Q4 2010 dip, smaller cap stocks could provide better return alpha than larger cap stocks. Notice the high ratio of proprietary trading on the TSE 1. In addition, another 10%~15% of trading is done completely off the exchange through so-called “dark pools”, making it ever more difficult for individual investors to anticipate short- to intermediate-price trends on TSE 1 stocks. Individual vs Foreigners & Prop Trading
Source: Tokyo Stock Exchange
Source: Tokyo Stock Exchange
Individual investors were net sellers of small cap stocks (TSE 2 and Tokyo Mothers listed) through the end of 2010, and were also net sellers throughout 2009. However, they recently became net buyers in the third week of January 2011 for the first week in 9 months. Overweight US Stocks and Neutral Japanese Stocks
Further, the big picture to date however is that Japanese equities are still lagging US stocks by a large margin. The chart below right compares the performance of the USDdenominated MSCI Japan and MSCI Japan Small Cap indices versus the S&P 500, NASDAQ (QQQ) and the ProShares Ultra Midcap 400. So far, any expectations that Japan stocks will outperform the U.S. benchmarks are just that, pure expectation, as the NASDAQ and higher beta market plays have substantially outperformed Japan since November 2010. Since the U.S. Fed is most aggressively pumping liquidity into the financial markets through QE2, it is only natural that most of this money is going into U.S. stocks. Further, the expected reversal in the JPY trade-weighted index has yet to occur. Global investors are overweighting US stocks, while moving previously underweight positions in Japan back to a neutral market-weight position of 7%~8% of global portfolios. For the time being, the incremental foreign fund flows needed to support higher Japanese equity prices are not coming from a re-allocation of funds away from the US market, but from BRICs and other emerging markets. In the early 1980s, this re-allocation would not have been enough to move the needle on Japanese equities. Then, moving 1% of assets out of Japan into other Asian markets would Subscribe or renew at www.japaninvestor.com
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TJI MARKET LETTER 11.01.31
have created a “bubble” in Asia. Now, however, Asia-Pacific equity market cap ex-Japan is nearly 28% versus under 8% for Japan, meaning that a re-allocation of assets out of other Asia markets now has a significantly positive impact on Japanese equities. JPY Index Still in Uptrend
MSCI Japan Small Caps Still Lagging US
Source: Yahoo.com
Source: BigCharts.com
World Market Cap Share
Source: World Federation of Exchanges
Japan’s Undersea Resource Development The waters surrounding Japan are a potential source of abundant rare metal and methane hydrate resources. The Government estimates the value of seabed mineral resources in its territorial waters at approximately USD2.3 trillion, which would make it one of the world's largest mineral deposits. In January 2011, the Japanese Government announced that it would lead a consortium to develop mining technologies to extract gold, silver, rare metals and methane hydrate from deep seabeds in Japan’s territorial waters. The Japanese government is backing efforts to complete research and development by 2018 and launch commercial production after that. The volume of methane hydrate in seafloor sediments around Japan alone is estimated to be enough to provide energy equivalent to 90 years of the nation's natural gas usage today. In 2007, the government announced that there were 1.14 trillion cubic meters of methane hydrates in a Pacific Ocean trench, the Nankai Trough, some 50 kilometers from the eastern coast of Honshu, the main Japanese island. This reserve is equivalent to almost 14 years of gas use by Japan at current rates – i.e., the equivalent of a giant gas oil field. Through the national Japan Oil, Gas and Metals National Corporation (JOGMEC), Japan is betting that it can extract and commercially exploit methane hydrate. Japan has few mineral resources to speak of and imports 99.7% of its crude oil, 87% of which comes from the Middle East. It has also found to its consternation that it’s most advanced technologies are highly dependent on rare earth exports from China. If successful, the JOGMEC gas drilling project could help Japan reduce a liquefied natural gas import bill that last year was JPY2.66 trillion ($23.3 billion) from the import of some 62.2 million metric tons (3.03 cubic feet) of LNG. The Japanese government has estimated that commercial exploitation of methane hydrate becomes economically viable when oil trades above $54 a barrel.
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TJI MARKET LETTER 11.01.31
Methane hydrate, also known as methane clathrate, hydromethane, methane ice or "fire ice", is a solid clathrate hydrate in which a large amount of methane is trapped within a crystal structure of water, forming a solid similar to ice. The worldwide amounts of methane bound in gas hydrates is conservatively estimated to total twice the amount of carbon to be found in all known fossil fuels on Earth. Methane clathrates in continental rocks are trapped in beds of sandstone or siltstone at depths of less than 800 m. Sampling indicates they are formed from a mix of thermally and microbially derived gas from which the heavier hydrocarbons were later selectively removed. These occur in Alaska, Siberia as well as Northern Canada. In 2008, Canadian and Japanese researchers extracted a constant stream of natural gas from a test project at the Mallik gas hydrate field in the Mackenzie River delta. This was the second such drilling at Mallik: the first took place in 2002 and used heat to release methane. In the 2008 experiment, researchers were able to extract gas by lowering the pressure, without heating, requiring significantly less energy. The sedimentary methane hydrate
reservoir probably contains 2–10 times the currently known reserves of conventional natural gas. This represents a potentially important future source of hydrocarbon fuel. However, in
the majority of sites deposits are likely to be too dispersed for economic extraction. Other problems facing commercial exploitation are detection of viable reserves; and development of the technology for extracting methane gas from the hydrate deposits. To date, there has only been one field commercially produced where some of the gas is thought to have been from methane clathrates, Messoyakha Gas Field, supplying the nearby Russian city of Norilsk.
The most efficient method of recovering methane clathrates has proved to be “depressurizing,” which requires deep bore holes being drilled into the ice sheets. Pressure within the chamber is reduced by a pump, causing gaseous methane to separate from the water and ascend to the well head. In March 2008, JOGMEC succeeded with Canadian counterparts in extracting methane from methane hydrate reserves under the tundra of northwestern Canada. This extraction from a deposit more than a kilometer below the Earth's surface has been hailed as the major breakthrough for which Japan had been waiting. The Central Research Institute of Electric Power Industry in Tokyo has developed technology that will absorb carbon dioxide to increase production of methane hydrate. This technology uses the heat of carbon dioxide for hydrate production and is expected to limit the emission of greenhouse gases. South Korean Commission and China Development South Korea’s Natural Resources and Energy Agency has commissioned JOGMEC to develop an undersea resource development system along with two private companies. China is also believed to be moving full-tilt toward establishing their own undersea resource development capabilities. China has initiated a long term national Program under the coordination of China Ocean Mineral Resources Research and Development Association (COW), to: a). Explore in COMRA'S registered Pioneer area in CC zone; b). Research in the field of Marine geological and geophysical studies; c). Develop a deep "sea-bed" mining system; d). Develop technology for manganese nodule processing and e) the construction of a data bank.
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TJI MARKET LETTER 11.01.31
Methane Hydrate Environmental Concerns Environmentalists however warn that a potential mass release of methane into the sea and the atmosphere is a risk for global warming. Ostensibly, undersea landsides triggered by volcanoes that occurred more than fifty million years ago resulted in the release of methane hydrate, contributing to global warming that lasted tens of thousands of years. Other concerns are that the separation of sea water and colder fresh water will cause ocean temperatures in the Nankai Trough to fall, negatively affecting. the area as a habitat for red sea bream, a fish delicacy. A bigger worry by environmentalists is evidence that the undersea ice may already be melting. A research party in the Sea of Japan in 2006 discovered methane gas bubbles rising from the ocean floor in the area. Methane hydrate proponents counter that, by capturing & burning the natural gas in ocean floor hydrates, we would be actually saving the planet from the future ruin we might incur if the deep oceans were to warm sufficiently—ostensibly due to the burning of fossil fuels like natural gas. Key Technologies Japan has leading-edge key technologies to support undersea resource development, including a) undersea robots and b) specialized drilling ships. Japan is developing a seafloor mining robot capable of operating at a maximum depth of 2,000 meters and equipped with a huge drill as well as a large-bladed excavating device that would be remote-controlled from a support vessel. The cost of developing the entire system, including the support vessel, is estimated between JPY20 billion and JPY30 billion yen. Japan is already operating the “Chikyu”, a 210 meter drilling ship with a drill that can drill down 10,000 meters and has computer tomography. Japan is also building another ship capable of boring 400 meters into the ocean floor that is scheduled to be completed in 2012. Japan Drilling The only play so far on Japan’s efforts to develop undersea resources is Japan Drilling (1606, JDC), which is listed on the first section of the Tokyo Stock Exchange. JDC is the sole offshore drilling contractor established and registered in Japan. JDC has been providing the high-quality drilling services worldwide such as in Gulf of Mexico, West Africa, Mediterranean Sea, Persian Gulf, Southeast Asia and Far East for the past 40 years. JDC is conducting drilling operations utilizing the state-owned deep sea Chikyu drilling vessel, the first riser-equipped scientific drilling vessel. JDC also provides quality offshore drilling services to oil and gas companies all over the world. JDC now operates three jack-ups, two semi-submersible and one drillship. JDC has built an international reputation as a drilling contractor with experienced and well trained work force through its 40 years' wide-ranging drilling services. The company conducts offshore drilling operations for essentially all of Japan’s oil explorers, as well as oil resource developers in China, Taiwan, the Philippines, Thailand, Malaysia, Viet Nam, Brunei, India and Indonesia. the Middle East, North America and Africa.
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TJI MARKET LETTER 11.01.31
Japan Drilling was listed in Tokyo in late 2009, when the stock price briefly hit JPY6,160 before the stock split 1:2 (creating an adjusted high of JPY3,080). After the split, the stock fell heavily as the initial holders of the offering allotment dumped their shares. It has recently hit a rebound high of JPY3,215 in rallying some 37% from a 2010 low of JPY2,346. The stock currently sells for a measly PER of 7X versus a market multiple of more like 16X and a PBR of 1.39X, while offering a dividend yield of 1.27%. Japan Drilling’s stock has seriously underperformed its global offshore drilling and engineering peers, and is selling at one of the lowest P/E multiples available in the sector even as ROE (profitability) is relatively higher than its peers. The valuation discount comes from cyclical earnings, as consolidated ordinary profit peaked at JPY14.1 billion in FY2009 but is expected to shrink to JPY5.7 billion in FY2011. The stock price however already appears to have discounted this. Japan Drilling Has Severely Lagged Peers
Comparative Fundamentals
Source: Google Finance
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TJI MARKET LETTER 11.01.31
Global Markets
Sources: FTSE, MSCI/Barra The consolidation in Asian/Emerging markets looks to continue, while there is increasing interest in Japanese small caps by both foreign and individual investors, as more switch from Asian markets to Japanese equities. By global sector, consumer staples and discretionary stocks have been doing some catch-up over the past month while financials have backed off a bit.
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TJI MARKET LETTER 11.01.31
Intermarket Analysis
Gold Futures
GSCI Agriculture Index
Source: StockCharts.com
Source: StockCharts.com
Copper Futures
USD Index
Source: StockCharts.com
Source: StockCharts.com
30Yr Treasury Price Index
JPY Index
Source: StockCharts.com
Source: StockCharts.com
Noticeably improved risk appetite and less alarmist view of fiat currencies beginning with the Euro has taken away the incentive to chase gold prices higher, but the strong rallies in copper as well as agricultural commodity markets show inflationary pressures continuing to build, forcing tighter monetary policy in emerging markets that is stunting equity rallies in these markets. In addition, the JPY Index shows no indication of a major breakdown and a major shift to a weakening trend. Thus despite high expectations, the strength of the JPY Index is limiting the upside for Japanese equity prices.
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TJI MARKET LETTER 11.01.31
Japan Market Charts Nikkei 225: Testing 50-Day EMA
JASDAQ Finally Sees a Golden Cross
JPY/USD: On the Cusp of a Golden Cross?
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TJI MARKET LETTER 11.01.31
Topix Sector Performance
Mining and textiles/apparel have taken the lead over the past month, while there are still lagging sectors like airlines, rubber products, broker/dealers, steel and other products as well as shipping.
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TJI MARKET LETTER 11.01.31
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TJI MARKET LETTER 11.01.31
Market Vane Indicator Market Technicals Market Trading Volume Yen Interest Rates Best Sector 1 Mo. Worst Sector 1 Mo. Economic Momentum
Closing Values
Direction Bullish
Indicator Topix
Week Close 919.69
Prev. Week 910.85
Bullish
NK225
10,360.34
10,274.52
Weakening
TSE 2
2,304.10
2,254.74
JASDAQ
54.26
53.24
JGB Yield (%)
1.210
1.210
Rubber Products
Yen-Dollar
82.64
82.94
Waning
EAFE ETF
60.27
58.92
Rising Real Estate
Sources: Tokyo Stock Exchange, Nikkei Financial, Yahoo.com
Japanese Small Caps Fund manager surveys in January show shift toward equities versus bonds, and a significant improvement in desired portfolio weightings for U.S. and Japanese equities has happened over the past month. On the other hand, investor sentiment toward emerging markets and commodities has visibly cooled. In 2010, small caps led the recovery in equity markets. But small cap performance in the U.S. has begun to lag, which is keeping with the historical pattern that small cap and large cap performance has roughly been the same in the second year following a recession. Basically, small cap outperformance is strongly tied to market direction. In other words, small-caps are pretty well correlated to large-caps but are about 30% more volatile. The small cap movement in Japan however is completely out of sync with the U.S. experience. Japan small caps peaked in Q1 2006, or over a year before the Nikkei 225 peaked. Small caps continued to lag until October 2008, because, a) Japan’s recovery much less clear, b) because of the yen’s surge to 15-year highs and c) because individual investors, which account for over 70% of t trading in small caps, were avoiding stocks. Further, the relative performance of Japanese small caps was completely eclipsed by dramatic recoveries in other Asian markets, including Indonesia, India, and Thailand. As the Asian markets consolidate, however, Japanese small caps---particularly small cap value—are visibly outperforming the Nikkei 225 and Topix. Further, they look poised to break out of the trading channel they have been entrapped in since 2009. Thus our preference is for Japanese small cap ETFs over Nikkei 225 constituents to maximize the relative performance of Japanese equities over Asian market competitors in the first half of 2011. The only exception to this view is the TSE Mothers, which continues to underperform. We do not, however, recommend shifting funds out of U.S. equities into Japanese equities, because U.S. equities (S&P 500 and NASDAQ) continue to outperform Japanese equities. Rather, we would be allocating funds away from the emerging and Asian markets in favor of Japan.
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TJI MARKET LETTER 11.01.31
TJI Model Portfolios
Sources: Tokyo Stock Exchange, Yahoo Japan, Yahoo
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TJI MARKET LETTER 11.01.31
Global Investor Sentiment Has Visibly Improved for the Developed Markets, Waned for Emerging Markets and Commodities The January 2011 BofA Merrill Lynch survey of global fund managers indicates that growing confidence in the economic recovery has raised global investor appetite for equities to its highest level in 3 1/2 years. A net 55% of asset allocators say that they are now overweight global equities, the highest reading since July 2007, and significantly higher than the net 40% overweight in December. At the same time, a net 54% are underweight bonds. Sentiment has significantly improved for U.S. equities, with 27% now saying they are overweight, which is the highest reading since November 2008 and significantly higher than the December 16%. Further, a net 15% would like to overweight U.S. equities more than any other region. Japan has also benefited, as global investors have moved overweight Japanese equities for the first time since May 2010 and for only the fifth month in 3 1/2 years. A net 5% of global fund managers are now overweight Japanese equities, compared with a net 29% underweight in November. Global emerging market sentiment remains high but continues to decline, with a net 43% saying they are overweight GEM equities, versus a net 56% two months ago. A net 20% are still overweight GEM equities more than any other region. Sentiment regarding commodities has also deteriorated, with a net 16% saying they are overweight, down six percentage points from the last month. This fall comes despite growing expectations of higher inflation. Basically, emerging markets can also be considered small cap stocks. Leveraging the Best Alpha From Japan: Small Caps Both academics and market practioners have well-documented the tendency of small cap stocks to outperform larger cap stocks in periods when the economy is emerging from recession. Comparing the S&P 500 large caps and S&P 600 small caps indexes over the past five recessions, we find that small caps rebounded on average 25.7% compared with 23.6% versus their large-cap counterparts in the three months between the trough and the end of the recession. Further, small caps vastly outperformed large caps--rising 26.8% compared with only 10.1%--in the first 12 months following the end of the recession. This small cap outperformance is at the core of the Fama-French Three-Factor Model, an economic theory used to describe market behavior based on Price/Book Value (P/B). So why does the research show small cap stocks tend to outperform large cap stocks over the long term? The simple answer is that small cap stocks are riskier, i.e., they are more volatile and have a higher Beta. Small-cap outperformance is strongly tied to market direction, i.e.,
small caps have consistently out-performed in bull markets and underperformed in bear markets.
It is therefore much more important for small cap investors where your entry point is. The two charts below show the pitfalls of a simple “small-cap stocks outperform” dogma. Over the 10 year period to end-2009, the surprise was that mid-caps, not small caps, outperformed. Further, despite all the supposed benefits of international diversification, the MSCI EAFE index has only just matched the S&P 500 large caps, but have lagged the midas well as small-caps.
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TJI MARKET LETTER 11.01.31
Between end 2001 and end 2010, the S&P 500 was basically flat, while performance of the S&P mid-cap and the S&P small-cap was virtually the same. Further, the red line in the chart below right shows how small caps perform in weak markets—i.e., badly. Mid Caps Actually Lead
Source: Marketsci Blog
Source: AXA Equitable, Japan Investor.com
Over the past year (see table below), small caps were outperforming in virtually every equity market except Japan in displaying the typical historical pattern of outperforming in the early stages of economic recovery. In 2011, however, small-cap YTD performance has lagged, as the U.S. consensus going into 2011 is that its time for lagging larger cap companies to outperform. This view is based on historical experience and actual market data YTD. In the second year following the recession, small caps and large caps have historically performed largely in line with each other, with small caps rising 7.2% on average versus 6.4% for the large caps, and they begin to lag from year three. Small Caps Outperformed in 2009, Now Lag
Source: BigCharts.com
Source: MSCI/Barra
Switching From Emerging Asia into Japanese Equities The move in Japanese small caps is out-of-sync with the U.S. Small caps in Japan peaked well before the overall peak in Japanese stock prices in 2007. The big peak for small caps in Japan was in early 2006, midway in the Junichi Koizumi-instigated clean-up of Japanese bank balance sheets, and the relatively strong GDP growth Japan enjoyed during the Koizumi reform years. In January 2006, the JASDAQ and small-cap Japanese stocks in general were hit hard by the Livedoor scandal, when corporate fraud resulted in large numbers of investors holding paper that was virtually value-less.
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TJI MARKET LETTER 11.01.31
The scandal uncovered a lot of loose accounting and auditor exceptions in companies listed on the Mothers and other junior exchanges. The 2009 recovery in Japan, while generally trending with overseas equity markets, was much less clear because of the yen’s surge to 15-year highs and a double dip in Japan’s economy in the last quarter of 2010 as domestic demand stimulus measures wore off. Further, the relative performance of Japanese small caps was completely eclipsed by dramatic recoveries in other Asian markets, including Indonesia, India, and Thailand. Japan Eclipsed in 2009, 2010 by Other Asia
But Inflation Concerns Now Stunt Asia Rally
Source: BigCharts.com. EWJ = Japan, INP =India, EWZ =Brazil, RBL = Russia
Source: Nikkei Astra
Going into 2011, however, hot emerging markets like China, Brazil and India are being
hobbled by central bank monetary tightening to get ahead of growing inflationary pressures, and once-hot markets like India are now testing medium-term downside resistance. Foreign
investors as well as domestic individual investors are now looking to Japan as the contrarian call (dark horse) for 2011 and foreign investors are restoring Japan weightings at least to a neutral position in their global portfolios. As individual investors recently account for over 80% of trading on the JASDAQ and well over 70% for all small caps, it is the foreign investors who have to watch what individual investors are doing.
The CityUK estimates that global assets under management rebounded 14% in 2009 to
just under USD80 trillion, the bulk of which are pension funds (USD28 trillion), mutual funds (USD22.9 trillion) and insurance funds (USD20.4 trillion). Global asset allocation for the top 500 as measured by Pension & Investments/Tower Watson’s World 500 as of 2008 shows these institutions structurally overweight the U.S. and Europe, underweight Japan and underweight emerging/other markets vis-à-vis the market cap share of these markets. However, as investors were piling into emerging markets in 2009 as they chased extremely strong performance, they probably have as much exposure to Asia/emerging markets as they want right now. Global Assets Under Management
Asset Allocation of the World’s Largest
www.TheCityUK.com
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www.TheCityUK.com
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Not All Japanese Small Cap Indices Created Equal However, differences in index construction and constituents show that all Japan small cap indices are not created equal. While all the Japan small cap indices are still below levels in 2007, the MSCI Japan Small Cap Value and MSCI Japan Small Cap Indices are outperforming by a wide margin, while the TSE Mothers index has performed especially poorly. MSCI Small Cap Indices Outperform
Performance of Japan Small Cap ETFs
Source: BigCharts.com
Source: Nikkei Amsus
The long bear market in Japan has taken its toll on sell-side research coverage, especially for smaller-cap issues. Consequently, overseas investors have trouble finding research or company disclosures in English for these companies and moreover, can get caught in individual names because of thin liquidity. For example, foreign hedge funds in 2006 were shorting larger-cap Japanese stocks and going long smaller-cap Japanese stocks that were being bought by individual Japanese investors. However, the Livedoor scandal sent individual investors fleeing from small caps, while the larger cap stocks actually outperformed—leaving the foreign hedge funds high-and-dry trying to liquidate individual positions in illiquid small cap stocks. It is therefore easier and less risky to invest through baskets of small-cap stocks, such as US-listed ETFs like JSC (SPDR Russel/Nomura Japan Small Caps), DFJ (Wisdom Tree Japan Small Cap Dividend) or SCJ (iShares MSCI Japan Small Cap Index). Unlike the static Tokyo Mothers index which includes a lot of chafe with the wheat, the constituents of these funds are regularly reviewed to weed out the weaker factors. The above chart shows that the performance of these ETFs is virtually the same, although SCJ has underperformed from time to time because of a higher weight in financials (currently at 17% versus 14% and 11% respectively for JSC and DFJ). Further, these indices
are breaking out to the upside, above interim highs in 2009 and 2010—which implies a run at 2007 highs, as other global markets also claw their way back to 2007, or pre-crisis, highs. But There Is Still Better Alpha Available in the US However, as everyone is aware, Japan still has some issues that will work to limit market upside. The first is that domestic investors have become structural net sellers of equities, which means they continue to basically be net sellers into foreign buying. This is a significant difference than the historical pattern, when foreign buying would elicit “coat tail” buying by Subscribe or renew at www.japaninvestor.com
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TJI MARKET LETTER 11.01.31
domestic investors. The second is the long-term drag from government debt that on a net basis is now over 100% of GDP. This is forcing the government to seriously consider a significant consumption tax hike and other austerity measures that could very well keep domestic demand below potential. The third is that much of the price formation in small cap stocks comes from individual investor trading, and thus individual investor participation is key to a sustainable rally. Thus as Japan’s economy pulls out of its Q4 2010 dip, smaller cap stocks could provide better return alpha than larger cap stocks. Notice the high ratio of proprietary trading on the TSE 1. In addition, another 10%~15% of trading is done completely off the exchange through so-called “dark pools”, making it ever more difficult for individual investors to anticipate short- to intermediate-price trends on TSE 1 stocks. Individual vs Foreigners & Prop Trading
Source: Tokyo Stock Exchange
Source: Tokyo Stock Exchange
Individual investors were net sellers of small cap stocks (TSE 2 and Tokyo Mothers listed) through the end of 2010, and were also net sellers throughout 2009. However, they recently became net buyers in the third week of January 2011 for the first week in 9 months. Overweight US Stocks and Neutral Japanese Stocks
Further, the big picture to date however is that Japanese equities are still lagging US stocks by a large margin. The chart below right compares the performance of the USDdenominated MSCI Japan and MSCI Japan Small Cap indices versus the S&P 500, NASDAQ (QQQ) and the ProShares Ultra Midcap 400. So far, any expectations that Japan stocks will outperform the U.S. benchmarks are just that, pure expectation, as the NASDAQ and higher beta market plays have substantially outperformed Japan since November 2010. Since the U.S. Fed is most aggressively pumping liquidity into the financial markets through QE2, it is only natural that most of this money is going into U.S. stocks. Further, the expected reversal in the JPY trade-weighted index has yet to occur. Global investors are overweighting US stocks, while moving previously underweight positions in Japan back to a neutral market-weight position of 7%~8% of global portfolios. For the time being, the incremental foreign fund flows needed to support higher Japanese equity prices are not coming from a re-allocation of funds away from the US market, but from BRICs and other emerging markets. In the early 1980s, this re-allocation would not have been enough to move the needle on Japanese equities. Then, moving 1% of assets out of Japan into other Asian markets would Subscribe or renew at www.japaninvestor.com
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TJI MARKET LETTER 11.01.31
have created a “bubble” in Asia. Now, however, Asia-Pacific equity market cap ex-Japan is nearly 28% versus under 8% for Japan, meaning that a re-allocation of assets out of other Asia markets now has a significantly positive impact on Japanese equities. JPY Index Still in Uptrend
MSCI Japan Small Caps Still Lagging US
Source: Yahoo.com
Source: BigCharts.com
World Market Cap Share
Source: World Federation of Exchanges
Japan’s Undersea Resource Development The waters surrounding Japan are a potential source of abundant rare metal and methane hydrate resources. The Government estimates the value of seabed mineral resources in its territorial waters at approximately USD2.3 trillion, which would make it one of the world's largest mineral deposits. In January 2011, the Japanese Government announced that it would lead a consortium to develop mining technologies to extract gold, silver, rare metals and methane hydrate from deep seabeds in Japan’s territorial waters. The Japanese government is backing efforts to complete research and development by 2018 and launch commercial production after that. The volume of methane hydrate in seafloor sediments around Japan alone is estimated to be enough to provide energy equivalent to 90 years of the nation's natural gas usage today. In 2007, the government announced that there were 1.14 trillion cubic meters of methane hydrates in a Pacific Ocean trench, the Nankai Trough, some 50 kilometers from the eastern coast of Honshu, the main Japanese island. This reserve is equivalent to almost 14 years of gas use by Japan at current rates – i.e., the equivalent of a giant gas oil field. Through the national Japan Oil, Gas and Metals National Corporation (JOGMEC), Japan is betting that it can extract and commercially exploit methane hydrate. Japan has few mineral resources to speak of and imports 99.7% of its crude oil, 87% of which comes from the Middle East. It has also found to its consternation that it’s most advanced technologies are highly dependent on rare earth exports from China. If successful, the JOGMEC gas drilling project could help Japan reduce a liquefied natural gas import bill that last year was JPY2.66 trillion ($23.3 billion) from the import of some 62.2 million metric tons (3.03 cubic feet) of LNG. The Japanese government has estimated that commercial exploitation of methane hydrate becomes economically viable when oil trades above $54 a barrel.
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TJI MARKET LETTER 11.01.31
Methane hydrate, also known as methane clathrate, hydromethane, methane ice or "fire ice", is a solid clathrate hydrate in which a large amount of methane is trapped within a crystal structure of water, forming a solid similar to ice. The worldwide amounts of methane bound in gas hydrates is conservatively estimated to total twice the amount of carbon to be found in all known fossil fuels on Earth. Methane clathrates in continental rocks are trapped in beds of sandstone or siltstone at depths of less than 800 m. Sampling indicates they are formed from a mix of thermally and microbially derived gas from which the heavier hydrocarbons were later selectively removed. These occur in Alaska, Siberia as well as Northern Canada. In 2008, Canadian and Japanese researchers extracted a constant stream of natural gas from a test project at the Mallik gas hydrate field in the Mackenzie River delta. This was the second such drilling at Mallik: the first took place in 2002 and used heat to release methane. In the 2008 experiment, researchers were able to extract gas by lowering the pressure, without heating, requiring significantly less energy. The sedimentary methane hydrate
reservoir probably contains 2–10 times the currently known reserves of conventional natural gas. This represents a potentially important future source of hydrocarbon fuel. However, in
the majority of sites deposits are likely to be too dispersed for economic extraction. Other problems facing commercial exploitation are detection of viable reserves; and development of the technology for extracting methane gas from the hydrate deposits. To date, there has only been one field commercially produced where some of the gas is thought to have been from methane clathrates, Messoyakha Gas Field, supplying the nearby Russian city of Norilsk.
The most efficient method of recovering methane clathrates has proved to be “depressurizing,” which requires deep bore holes being drilled into the ice sheets. Pressure within the chamber is reduced by a pump, causing gaseous methane to separate from the water and ascend to the well head. In March 2008, JOGMEC succeeded with Canadian counterparts in extracting methane from methane hydrate reserves under the tundra of northwestern Canada. This extraction from a deposit more than a kilometer below the Earth's surface has been hailed as the major breakthrough for which Japan had been waiting. The Central Research Institute of Electric Power Industry in Tokyo has developed technology that will absorb carbon dioxide to increase production of methane hydrate. This technology uses the heat of carbon dioxide for hydrate production and is expected to limit the emission of greenhouse gases. South Korean Commission and China Development South Korea’s Natural Resources and Energy Agency has commissioned JOGMEC to develop an undersea resource development system along with two private companies. China is also believed to be moving full-tilt toward establishing their own undersea resource development capabilities. China has initiated a long term national Program under the coordination of China Ocean Mineral Resources Research and Development Association (COW), to: a). Explore in COMRA'S registered Pioneer area in CC zone; b). Research in the field of Marine geological and geophysical studies; c). Develop a deep "sea-bed" mining system; d). Develop technology for manganese nodule processing and e) the construction of a data bank.
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TJI MARKET LETTER 11.01.31
Methane Hydrate Environmental Concerns Environmentalists however warn that a potential mass release of methane into the sea and the atmosphere is a risk for global warming. Ostensibly, undersea landsides triggered by volcanoes that occurred more than fifty million years ago resulted in the release of methane hydrate, contributing to global warming that lasted tens of thousands of years. Other concerns are that the separation of sea water and colder fresh water will cause ocean temperatures in the Nankai Trough to fall, negatively affecting. the area as a habitat for red sea bream, a fish delicacy. A bigger worry by environmentalists is evidence that the undersea ice may already be melting. A research party in the Sea of Japan in 2006 discovered methane gas bubbles rising from the ocean floor in the area. Methane hydrate proponents counter that, by capturing & burning the natural gas in ocean floor hydrates, we would be actually saving the planet from the future ruin we might incur if the deep oceans were to warm sufficiently—ostensibly due to the burning of fossil fuels like natural gas. Key Technologies Japan has leading-edge key technologies to support undersea resource development, including a) undersea robots and b) specialized drilling ships. Japan is developing a seafloor mining robot capable of operating at a maximum depth of 2,000 meters and equipped with a huge drill as well as a large-bladed excavating device that would be remote-controlled from a support vessel. The cost of developing the entire system, including the support vessel, is estimated between JPY20 billion and JPY30 billion yen. Japan is already operating the “Chikyu”, a 210 meter drilling ship with a drill that can drill down 10,000 meters and has computer tomography. Japan is also building another ship capable of boring 400 meters into the ocean floor that is scheduled to be completed in 2012. Japan Drilling The only play so far on Japan’s efforts to develop undersea resources is Japan Drilling (1606, JDC), which is listed on the first section of the Tokyo Stock Exchange. JDC is the sole offshore drilling contractor established and registered in Japan. JDC has been providing the high-quality drilling services worldwide such as in Gulf of Mexico, West Africa, Mediterranean Sea, Persian Gulf, Southeast Asia and Far East for the past 40 years. JDC is conducting drilling operations utilizing the state-owned deep sea Chikyu drilling vessel, the first riser-equipped scientific drilling vessel. JDC also provides quality offshore drilling services to oil and gas companies all over the world. JDC now operates three jack-ups, two semi-submersible and one drillship. JDC has built an international reputation as a drilling contractor with experienced and well trained work force through its 40 years' wide-ranging drilling services. The company conducts offshore drilling operations for essentially all of Japan’s oil explorers, as well as oil resource developers in China, Taiwan, the Philippines, Thailand, Malaysia, Viet Nam, Brunei, India and Indonesia. the Middle East, North America and Africa.
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TJI MARKET LETTER 11.01.31
Japan Drilling was listed in Tokyo in late 2009, when the stock price briefly hit JPY6,160 before the stock split 1:2 (creating an adjusted high of JPY3,080). After the split, the stock fell heavily as the initial holders of the offering allotment dumped their shares. It has recently hit a rebound high of JPY3,215 in rallying some 37% from a 2010 low of JPY2,346. The stock currently sells for a measly PER of 7X versus a market multiple of more like 16X and a PBR of 1.39X, while offering a dividend yield of 1.27%. Japan Drilling’s stock has seriously underperformed its global offshore drilling and engineering peers, and is selling at one of the lowest P/E multiples available in the sector even as ROE (profitability) is relatively higher than its peers. The valuation discount comes from cyclical earnings, as consolidated ordinary profit peaked at JPY14.1 billion in FY2009 but is expected to shrink to JPY5.7 billion in FY2011. The stock price however already appears to have discounted this. Japan Drilling Has Severely Lagged Peers
Comparative Fundamentals
Source: Google Finance
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TJI MARKET LETTER 11.01.31
Global Markets
Sources: FTSE, MSCI/Barra The consolidation in Asian/Emerging markets looks to continue, while there is increasing interest in Japanese small caps by both foreign and individual investors, as more switch from Asian markets to Japanese equities. By global sector, consumer staples and discretionary stocks have been doing some catch-up over the past month while financials have backed off a bit.
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Intermarket Analysis
Gold Futures
GSCI Agriculture Index
Source: StockCharts.com
Source: StockCharts.com
Copper Futures
USD Index
Source: StockCharts.com
Source: StockCharts.com
30Yr Treasury Price Index
JPY Index
Source: StockCharts.com
Source: StockCharts.com
Noticeably improved risk appetite and less alarmist view of fiat currencies beginning with the Euro has taken away the incentive to chase gold prices higher, but the strong rallies in copper as well as agricultural commodity markets show inflationary pressures continuing to build, forcing tighter monetary policy in emerging markets that is stunting equity rallies in these markets. In addition, the JPY Index shows no indication of a major breakdown and a major shift to a weakening trend. Thus despite high expectations, the strength of the JPY Index is limiting the upside for Japanese equity prices.
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Japan Market Charts Nikkei 225: Testing 50-Day EMA
JASDAQ Finally Sees a Golden Cross
JPY/USD: On the Cusp of a Golden Cross?
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Topix Sector Performance
Mining and textiles/apparel have taken the lead over the past month, while there are still lagging sectors like airlines, rubber products, broker/dealers, steel and other products as well as shipping.
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TJI MARKET LETTER 11.01.31
NOTICE: While the information and opinions contained in this report have been compiled by The Japan Investor PTY, LTD. from sources believed to be reliable, we do not represent that it is accurate or complete and it should not be relied upon as such. Accordingly, nothing in this report shall be construed as; 1) offering a guarantee of the accuracy or completeness of the information contained herein, and 2) an offer to sell or a solicitation of an offer to buy securities. Any opinions expressed herein reflect our judgment at the date of the report and are subject to change. The Japan Investor PTY, LTD. may at any time have a long or short position in any security or option mentioned in this report. In such cases, such positions will be disclosed in a note in the report. Each recipient of this report, by their acceptance hereof, warrants that they understand the risks involved in dealing in the securities or any related investments or instruments and shall not distribute this report to any other persons. This report is not intended for public distribution. This report may not be reproduced, distributed–in whole or in part–by any recipient without the prior written consent of The Japan Investor PTY, LTD. Photocopying of the Japan Investor is Illegal. Reproduction of any part of this publication by any means will be held as an international violation of copyright laws unless specifically authorized by the publisher. If you would like to reproduce any part of The Japan Investor, please write to [email protected], and include the source of your quote and an email address with your request, as well as where and when the excerpt will be reproduced.
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