J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 57
Tuesday, December 16, 2003
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++ Viewpoint: Secular or Cyclical? The Market Will Tell in Early '04
The Bottom Line:
o In Money Watch No. 45 in late September, we observed that it
made no difference to stock market performance in 2003 whether
the current economic recovery was secular or cyclical, but
that it would become a real issue as regards the
sustainability of the market rally in 2004.
o We believe that the stock market itself (as a leading
indicator) will make this clearer in the first quarter of
2004. Historically, the Nikkei and Topix have given warnings
of an approaching peak in economic activity four to six months
ahead of time.
o If the Topix fails to renew recent highs during the first
quarter of next year despite the currently upbeat economic
data, the implication is that Japan's economy will peak in the
first half of next year, as some economists are already
o In Money Watch No. 54, we cautioned investors not to become
too enamored of large-cap companies with still large cross-
holdings and large holdings by parent companies, as the Tokyo
Stock Exchange was apparently studying introduction of a
float-adjusted Topix benchmark.
o There is upwards of 15 trillion yen in pension funds being
passively indexed to the Topix. Moreover, many domestic
managers of public pension funds are basically "closet
indexers." Money Watch believes this will have a significant
impact on companies both slated to go into the Topix benchmark
and on companies currently included in the index that will not
be part of the new Topix 1,000 Float.
o Relative weights of NTT, NTT Docomo and NTT Data, for example,
would have to be lowered under the new benchmark, while
companies like Toyota, Mitsubishi Tokyo FG, Honda and Canon
will benefit as their relative weight in the new index is
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++ Viewpoint: Secular or Cyclical? The Market Will Tell in Early '04
The Bank of Japan on Friday began final adjustments to revise upward
its economic assessment for the fourth straight month in its upcoming
economic outlook. In its December "Monthly Report of Recent Economic
and Financial Developments," the BOJ is expected to change the
economic assessment from "starting to recover gradually" to
"recovering gradually." The BOJ's Policy Board will make a final
decision when it holds a meeting next week.
Overall, the BOJ's tankan quarterly business survey released on Friday
carried an upbeat message, particularly regarding manufacturing. It
underscored the view that recovery in Japan's economy continues to
The diffusion index for large manufacturers jumped 10 points from
September to 11, representing the third straight quarter of
improvement and the highest absolute level since June 1997. The
sectors that showed the most dramatic recoveries in business sentiment
were: nonferrous metals (from -35 in September to +10), petroleum &
coal (-29 to 0), wood products (-11 to +11), leasing (-11 to +11),
processed metals (-7 to +14), textiles (-34 to -14), utilities (-6 to
+12), precisions (0 to +15), electrical machinery (-5 to +7),
wholesaling (+4 to +16) and motor vehicles (+24 to +35).
However, the future outlook for March declined to 8 for the major
manufacturers. A closer examination of the survey reveals areas of
concern -- particularly weakness in household spending and the
potential negative impact of yen appreciation -- that raise questions
about the sustainability of the recovery. "A sense of caution about
the outlook is growing," says Kakutaro Kitashiro, chairman of the
influential business group Keizai Doyukai. "I am not optimistic about
the sustainability of the recovery."
We have been here before. Prior cycles in 1996 and 2000 were peaking
just as sentiment was reaching its high point in the last two business
cycles. While the bulls suggest: a) that this time is different, and
b) that there is room for more positive economic surprises, Money
Watch would instead look at the stock market's action for the
strongest indicator of whether this time will indeed be different.
On average, the median lead-time the market has peaked ahead of the
economic cycle during the entire postwar period is four months; it's
six months during the post-bubble period. If the stock market gives us
a quarter-plus of lead-time as it has historically, the Topix will
have to renew its prior high of 1,114.4 in the first quarter of next
year. If it consolidates more instead, this failure to establish a new
high will be indicative of a peaking in economic growth in the first
half of fiscal 2004.
As it turns out, the Tokyo Stock Exchange has already developed the
Topix 1,000 Float index, which ranks the top 1,000 Topix constituents
in terms of market capitalization, then adjusts this capitalization
for cross-holdings and parent company holdings. The calculation of the
floating shares for each company in the new index will be reviewed
once a year, and adjustments to the index will be made accordingly.
It appears that the exchange developed the new index in response to
pressure from the nation's pension fund managers. Nikkei Financial
reported on Friday that Mitsui Asset Trust Bank has already set up a
fund based on the new index which they will be marketing to pension
The total market capitalization of the top 20 companies with high
parent-company holding ratios is over 31 trillion yen. As the median
parent company holding of these companies is around 51 percent,
adjusting the Topix for the "free float" for these companies and
paring the target universe down to 1,000 companies instead of the
1,543 companies currently in the Topix would reduce stated market
capitalization represented in the index by 10 percent.
Needless to mention, given a new free-float-adjusted benchmark,
domestic investors would have to adjust their weightings of such
companies accordingly. In NTT Docomo's case, for example, that would
mean that NTT's stated market cap would drop from 11.8 trillion yen
currently to only 4.4 trillion yen, and its weight in a new
float-adjusted index would go from around 4 percent presently to less
than 2 percent. This would be a disaster for the company's stock
price. Conversely, the relative weight of large-cap companies with
good free floats would benefit.
Moreover, because the new index will contain just 1,000 instead of
over 1,500 companies, over 500 companies would ostensibly be dropped
from the "investibles" universe of pension funds adopting this
benchmark. Additionally, adjusting the float of all current Topix
constituents would also mean that a large number of companies with
minimum market capitalization above 100 billion yen(size of market
capitalization is another screen used by big institutions to insure
that market liquidity is sufficient enough to trade in big blocks of
the company's shares).
Our rough estimates of the amount of domestic corporate and public
pension money that is managed passively (i.e., in strict accordance
with their benchmark index) is upwards of 15 trillion yen. Moreover,
fund managers who manage the big public pension money are basically
"closet indexers," i.e., they normally do not diverge much from what
is basically a "passive" investment stance.
Consequently, as previously stated, Money Watch believes that: a)
Because the new index was driven by the needs of the big domestic
pension funds, it has a good chance of becoming a viable alternative
benchmark index for these funds; and b) it therefore will exert an
increasing influence on Japanese stock prices. How much influence can
be imagined by the speculative trading that is done whenever the
Nikkei or the MSCI Japan makes changes in their current list of index
constituents. As more big pension money is managed using the Topix
1000 Float, the less of this money there will be for big companies
like NTT Docomo or Nissan, because according to the new index, the
pension funds would already be holding too much of these stocks.
-- Darrel Whitten
Money Watch No. 45
Money Watch No. 54
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