MW-70 -- Japan Continues to Surprise on the Upside

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 70
Tuesday, March 30, 2004
Tokyo

CONTENTS
@@ VIEWPOINT: Japan Continues to Surprise on the Upside

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@@ VIEWPOINT: Japan Continues to Surprise on the Upside

The Bottom Line:

o There are three possible scenarios for the US market currently
being debated: 1) This is a healthy correction in a bull
market; 2) it represents the early stages of a long-term
trading range; or 3) it is the beginning of a bear market.

o Money Watch votes for the first scenario. From a longer-term
perspective, Nasdaq is in the first year of a recovery from
the bursting of a "bubble" that tacked on over 4,000 points to
the index from 1996 to 2000. From 2000 to 2002, Nasdaq
essentially erased all of those bubble gains, shedding 3,760
points, or over 70 percent. Consequently, Nasdaq has so far
recovered only some 20 percent of the value lost between 2000
and 2002.

o Money Watch believes that the current correction is merely a
speed adjustment as the stock market adjusts to the reality
that this particular recovery is not a garden variety
recovery, where a continued economic recovery begins to
generate job growth, and a "demand-pull" inflationary
environment slowly begins to emerge. Under this scenario,
Nasdaq and US markets maintain a positive bias, but market
returns are slowed by a gradual shift from excess liquidity to
earnings fundamentals, while slowly rising rates inhibit any
expansion in market multiples that would give an extra kick to
market returns.

o As for the implications for Japanese equities, a positive
Japanese scenario is not contingent on a rosy US outlook.
Depending on how rapidly Japan can emerge from its Heisei
Malaise, it could completely de-couple from the US and sustain
upside momentum even given the re-emergence of a bear market
in the US. Japan's Topix, after hitting a post-bubble low of
770.46, passed its first recovery milestone late last year in
breaking through 1,000, a level that had been a support line
on two occasions during the Heisei Malaise. The next milestone
is 1,200, a support level on three occasions during the Heisei
Malaise and probably one of the most-defended levels on the
Topix for the past eight years.

o Unlike past rallies during the Heisei Malaise, the current
rally in Japanese equities is not supported by a big policy
stimulus package or by government efforts to bend economic
forces in much the same way one would bend and control the
development of a bonsai tree. It is indigenous and came
about as the result of grass-roots restructuring, the extent
of which has now become increasingly obvious even at the
aggregate level.

o Since May of last year, the Tokyo market has, with the
exception of brief corrections in July-August 2003,
October-November 2003 and January-February 2004, continued to
outperform the S&P 500. Given our expectation of more active
buying by domestic institutions with the onset of the new
fiscal year from April 1, 2004, we would expect this
outperformance to continue at least through the next quarter
and very likely beyond it.

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@@ VIEWPOINT: Japan Continues to Surprise on the Upside

US investors are fixated on the lack of job growth in the current
recovery, first because it is unusual at this stage of the economic
recovery, and secondly, because it has become a political football in
the presidential election race. US payrolls have grown by 61,000
workers on average over the last six months, less than a third of
the average gain during the same period after the 1990-1991
recession. Some analysts have even suggested that the US economy
is being set up for stagflation, where there is no real recovery
that produces jobs, only rising inflation and tepid growth. But
despite the perceived lack of job creation, US personal spending rose
for the fifth straight month in February, and consumer confidence
unexpectedly climbed in March, suggesting the economy will continue to
grow. Americans' spending last month rose 0.2 percent after a 0.5
percent gain in January that was larger than first estimated, the
Commerce Department reported in Washington. Personal incomes climbed
0.4 percent, the most since November, and the University of Michigan
said its March sentiment index rose from a preliminary reading two
weeks ago.

Moreover, inflation remains in check, despite the biggest rallies in
major commodities in 20 years and the weak dollar. The Commerce
Department's measure of inflation tied to spending, the personal
consumption expenditure price index, climbed 0.2 percent last month.
The index excluding volatile food and energy prices, a gauge followed
by Greenspan and other policy makers, edged up 0.1 percent last month,
capping a 1.1 percent rise since February 2003. The increase over the
past 12 months compared with a 0.8 percent year-on-year gain in
December that matched the lowest since record-keeping began in 1960.
This is one of the most important reasons that the US Federal Reserve
can remain patient about changing monetary policy gears. In addition,
the Fed is savvy enough to realize that pulling the trigger too early
on interest rates would not be the politically correct thing to do in
an election year, particularly one that is as bitterly contested as
this election promises to be.

This notwithstanding, the 10-year US Treasury had its biggest decline
in two months after the rise in the inflation measure and consumer
confidence. The 4 percent note due in February 2014 fell, boosting its
yield 9 basis points to 3.83 percent. But this uptick is within the
confines of a continuous decline in US bond yields since the "rates
scare" in August-September 2003. US 10-year TB yields are still 147
basis points lower than they were in March 2002, before the blowout
2003 third quarter GDP numbers raised all the speculation about a
possible change in monetary policy by the Fed.

The debate among US investors about the correction currently under way
in the US and among those who closely follow the US markets overseas
(which means essentially anybody who invests in equities) is:

a) Is this a healthy correction in a secular bull market, or

b) Does this represent the early stages of an emerging
long-term trading range, or

c) Is this the beginning of a bear market?

Over the past 52 weeks, the Nasdaq composite has surged 61 percent
trough to peak, while the recent correction has knocked off 12 percent
of the index. The fact that most of the US benchmark indexes have
fallen through their 50-day moving averages means the current
correction is more extended than any seen so far in the recovery
rally, but it does not necessarily mean either the beginning of an
extended sideways trading channel or the beginning of a new bear
market. During the run-up over the past year, Nasdaq tacked on 817
points, while recent movement represents a 31-percent retracement of
the latest rally.

From a longer-term perspective, Nasdaq is in the first year of a
recovery from the bursting of a bubble that tacked on over 4,000
points to the index from 1996 to 2000 to historic highs of over 5,000.
From 2000 to 2002, Nasdaq essentially erased all of those bubble
gains, shedding 3,760 points, or over 70 percent. Consequently, Nasdaq
has so far recovered only some 20 percent of the value lost between
2000 and 2002. This indicates to us that Nasdaq's recovery is just
getting started. This would seem to rule out (c) the "beginning of a
bear market" scenario. What about (b) "early stages of a long-term
trading range"?

Of the two bearish scenarios, this is the more likely if: 1) The
dollar remains in a multiyear bear market; 2) the US finds it
difficult to get a handle on its balance of payments deficit and
fiscal deficits; and 3) the US economy sputters from the second half
of this year. Under this scenario, the US economic recovery would
begin to run out of steam just as companies are attempting to pass on
significant increases in oil, copper and other basic materials to
their users, while the Fed would be under increasing pressure to adopt
a more restrictive monetary policy as rising prices in upstream
commodities filter their way downstream through the economy, as is
already being seen in gasoline prices. In other words, the economy
stagnates while inflation pressures continue to build, and corporate
profits are hit by a double whammy of weakening demand and steadily
increasing interest rates, a classic stagflation scenario. Under this
scenario, Nasdaq could peak at 2000, with 1000 defining the lower end
of an extended trading channel.

Money Watch subscribes to scenario "a." The current correction is
merely a speed adjustment as the stock market adjusts to the reality
that this particular recovery is not a garden variety recovery where a
continued economic recovery begins to generate job growth and a
"demand-pull" inflationary environment slowly begins to emerge,
compelling the Fed to take its inflation hat out of the closet and
begin slowly tightening monetary policy. Under this scenario, Nasdaq
and other US markets maintain a positive bias, but market returns are
slowed by a gradual shift from excess liquidity to earnings
fundamentals, while slowly rising rates inhibit any expansion in
market multiples that would give an extra kick to market returns.

Of the above scenarios, (a) and (b) would be bullish for Japanese
equities as they would imply that Japanese stocks continue to
outperform US stocks for the foreseeable future. In addition,
depending on how rapidly Japan can emerge from its Heisei Malaise, it
could completely de-couple from the US and sustain upside momentum
even given the re-emergence of a bear market in the US. The
re-emergence of a bear market in US equities would imply that the US
economy slips into its own version of the Heisei Malaise, a decade of
limp economic growth, declining global competitiveness, balance sheet
fragility and soaring deficits.

Japan's Topix, after hitting a post-bubble low of 770.46, passed its
first recovery milestone late last year in breaking through 1,000, a
level that had been a support line on two occasions during the Heisei
Malaise. The next milestone is 1,200, a support level on three
occasions during the malaise and probably one of the most-defended
levels on the Topix for the past eight years.

Unlike past rallies during the Heisei Malaise, the current rally in
Japanese equities is not supported by a big policy stimulus package or
by government efforts to bend economic forces in much the same way one
would bend and control the development of a bonsai tree (the
ineffectual Reconstruction Corp. of Japan is a case in point). It is
indigenous and came about as the result of grass-roots restructuring,
the extent of which has now become increasingly obvious even at the
aggregate level.

According to a research paper by the Bank of Japan (BOJ Economic
Commentary Number 2004-01, "Will Japanese Companies Ever Achieve a
Full-Fledged Recovery?" by Sohei Kaihatsu), continuously available
data on 1,201 companies listed on the Tokyo Stock Exchange from
fiscal 1990 to fiscal 2003 shows that aggregate return on equity
plunged from 8 percent in fiscal 1990 to a low of under 1 percent in
fiscal 2001 and has now recovered to 7.5 percent in fiscal 2003, a
level higher than the fiscal 1996 and 2000 rebound levels of around 5
percent. The harrowing experience of the 1997-98 financial crisis in
Japan taught Japanese companies to prioritize balance sheet health and
creditworthiness. As a result of these efforts, the net differential
between credit upgrades and downgrades of Japanese companies by credit
agencies finally turned positive in fiscal 2003.

During the Heisei Malaise, improvements during the first cyclical
recovery in 1996 gave way to plunging credit ratings in fiscal 1998
and another temporary improvement in fiscal 2000, which was
subsequently reversed. Reflecting the bottom-up improvement in
balance sheets and the improved prognosis for Japan's economy,
the multinational rating agencies now even have Japan's sovereign
debt on positive credit review, even though Japan's total
government debt has reached $6 trillion and is expected to grow
to $6.6 trillion by fiscal 2005, representing $50,000 for every
man, woman and child in Japan.

Confidence in Japan's Future Continues to Deepen
Hedge funds were among the first to express confidence in Japan's
future early last year. During the year, they are thought to have
doubled their exposure to Japan. Daiwa has estimated that investment
in Japan stocks by 5,500 global hedge funds at the end of 2003 was
about 7.68 trillion yen ($71.8 billion) for the year, versus about
$34.1 billion in 2002. While not completely convinced of a sustainable
economic recovery, individual investors began to come back in the
market, actively trading their portfolios through online brokers.
Foreign investors were encouraged by the substantial improvement in
business confidence, as reflected in the BOJ's tankan business
sentiment survey. At first, domestic institutional investors, as
cautious as ever, dismissed the rally as a transitory phenomenon
driven mainly by a cyclical uptick in the economy and corporate
profits that was being driven by tenuous overseas demand.

Increasingly, however, the person in the street is also becoming more
confident, as the Cabinet Office's "Business Condition Watcher" survey
indicates. This increased confidence by the person in the street is
being reflected in a recovery in personal consumption expenditures.
Salaried worker household expenditures were up 6.9 percent in real
terms in February, the fourth consecutive year-on-year gain. Even
supermarkets and department stores had a good month, recording sales
gains of 1.2 percent and 2.3 percent, respectively.

Since May of last year, the Tokyo market has, with the exception of
brief corrections in July-August 2003, October-November 2003 and
January-February 2004, continued to outperform the S&P 500. Given our
expectation of more active buying by domestic institutions with the
onset of the new fiscal year from April 1, we would expect this
outperformance to continue at least through the next quarter, and it
could very well continue to outperform the US market for the
foreseeable future, especially if the more bearish scenarios as
previously outlined for the US market come to pass.

What Sectors and Stocks to Consider Now
Given that the Japanese market should: a) continue to rally and b)
continue to outperform its US counterpart, the market will be
characterized by sector-rotational buying, with sector leadership
occasionally shifting as investors move to those sectors that have
been recently underperforming the overall market's rise. As pointed
out in previous market letters, small cap stocks have led the charge,
followed by basic materials companies, finance (banks) and now retail
as well as real estate. Left at the train station has been
telecommunications and, more recently, other technology stocks,
including semiconductor related stocks.

Large-cap blue-chip stocks have recently been playing catch-up, and we
would expect them to do better as domestic institutions become more
involved in the ongoing rally. In addition, technology stocks are
looking increasingly like latecomers. The US tech sector initially led
the US rally, outperforming the S&P 500 between August 2003 and
January of this year. After peaking at 22.24 in January, however, the
Amex-listed technology SPDR (code: XLK) led the market downward in
correcting some 13 percent. It has now bounced off its 200-day moving
average of 19.25 and looks set for an interim rally.

Tokyo Electron (TEL, 8035), one of Japan's most globally competitive
high-tech firms, has been consolidating since September 2002 after
initially outperforming the Tokyo rally. Tech investors fear that the
silicon cycle will peak in 2005, and therefore, the recovery is
already factored into stock prices. Given the good order numbers being
seen, however, it does appear that investors have punished such
high-tech stocks too severely, as tech stocks like TEL have
essentially been going in the opposite direction of the overall market
for the last seven months.

-- Darrel Whitten

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