Japan: The Big Picture Revisited

Back to Contents of Issue: June 2005

by Darrel Whitten

More Post Bear Market Bounce, then Long-Term Consolidation?

To find an example similar to Japan's "Heisei Depression," one has to go all the way back to the 1920s and the Showa Depression. In the Showa Depression, stock prices fell some 74 percent over a twelve-year period, while property prices fell for 14 consecutive years. During the Heisei Depression, Japanese stock prices fell 80 percent peak-to-trough, while property prices have also been falling for some 13 years. Central banks and investors around the world breathed a sigh of relief when it became increasingly clear that the 7,600 low in the Nikkei 225 in April 2003 was the trough of the Heisei Depression. Stock prices have subsequently bounced some 60 percent to rebound highs in 2004.

If the post-Heisei Depression bounce is anything like the 2.5-fold bounce after the Showa Depression, however, the current rally has much farther to go, i.e., to perhaps as far as 19,000.

The other lesson of the post-Showa Depression market, however, is that stock prices went into a 10-year consolidation after an initial bounce - from around 1935 to 1945. If the post-Heisei Depression market acts in a similar fashion, the Nikkei 225 could continue consolidating to 2016 following the aforementioned bounce that could take the index to 19,000.

But I believe this scenario is both bullish for short-term investors and long-term investors (such as domestic pension funds). This is because short-term investors can look forward to good gains in 2006, while long-term investors can take the next ten years continuously accumulating stock for the next secular bull market in Japan.

Thus while the Tokyo market is beginning to show signs of being top-heavy on the upside amidst growing concern of a cyclical peak in the economy and corporate profits, I believe that investors should not be overly concerned about the short-term, but instead should keep the big picture in mind and basically maintain a "buy on weakness" stance toward Japan.

The big picture suggests that it is now Japan's turn to undergo a major secular revitalization.

Similarities to the Showa Depression
The Heisei "depression" was unprecedented in modern Japanese and global economic history, yet had many similarities to the Showa Depression in the 1920s, which was the only other major deflationary depression in Japan in recorded market history. Then, stock prices peaked (end of month) in December 1919 and entered a secular bear market, which included a major crash. This bear market lasted some 12 years until November 1931, when the Nikkei equivalent bottomed some 74 percent lower than its peak in 1919. There was also a 14-year bear market in property prices.

The damage to stock prices was so great from the Showa Bear Market that it took roughly 10 years after the initial bottom and a "modest" 2-year bounce of 2.46X trough-to-peak for the market to fully recover.

As previously explained, the Nikkei 225 bottom at 7,600 marked the end of the secular Heisei Bear Market. Relieved foreign and individual investors piled back into Japanese stocks, pushing the Nikkei 225 back to a rebound high of 12,196 in April 2004, for a handy 60 percent gain.

But compared to the post secular trough rebound following the Showa Depression of 2.5-fold, the Heisei Depression "bounce" may have more legs. If this bounce were to be as large as the Showa Depression's bounce, the Nikkei 225 could rally to 19,000 over the next year.

The problem is what comes after that. After the initial bounce following the secular low in the Showa Depression, the market essentially went sideways (or traded in a "box" market) for the next 10 years, i.e., between 1935 and 1945. If a similar phenomenon were to occur after the current "bounce" is completed, the Nikkei 225 could essentially trade sideways until 2016, but not before a substantial rally occurs.

Thus the bottom line of a comparison of the aftermath of the Showa Depression with the Heisei Depression is, a) Japanese stocks still have plenty of room for a short-term "bounce" over the next year, and b) the market could consolidate for the next 10 years after this bounce.

For today's short-term oriented investors, this is a very bullish scenario. But it is also a bullish scenario for patient long-term investors, who could spend the next 10 years accumulating Japanese stocks in anticipation of the next secular bull market.

Historical Bear Markets -- None Like the Heisei Bear Market
Japan has seen eight cyclical bear markets as defined by "more than a 20 percent correction" since 1950, but four of these were during the secular bear market of the Heisei Depression.

In other words, there were only four cyclical bear markets in Japan in the 39 years from 1950 to 1989, with the average loss being 41 percent and the average duration being 20 months. In comparison, the US market has seen 10 bear markets (by the same definition) since 1956, with the average loss being around 30 percent -- three in the 1960s, two in the 1970s, two in the 1980s, one in the 1990s and one so far in the 2000s.

Conversely, the average cyclical bull market gain prior to the Heisei Depression from the 1950s in Japan was more like a five-fold surge. Then, Japan's economy was returning to normalcy after the ravages of World War II. It is therefore highly unlikely that such gains will be seen in the next secular bull market in Japan. That being said, the Nikkei 225 would have to soar 3.5-fold from current levels just to meet its prior historical high of 38,900 set in December 1989. If history repeats (or merely rhymes) and my suggested scenario unfolds (i.e., the market bounces further and goes into long-term consolidation before entering the next secular bull market), the move to the previous historical high will be from a higher plateau. Even from a higher plateau of, as previously suggested, 19,000, a return to prior highs would still suggest a bull market appreciation of over two-fold in the next secular bull market.

The Implication is that it is Now Japan's Turn for Major Revitalization
Following the "lost 1980s" and most of the 1990s, the US staged a major revival, with the Dow Jones breaking out of a decade-long trading range in the 1980s, and leading to a massive rally in stock prices in the 1990s.

Now, however, the old nemesis of the US has returned more virulent than ever -- i.e., the US is piling on trade deficits and budget deficits at a scale that simply cannot be absorbed indefinitely, even through massive purchases of US treasuries by foreign central banks, or even renewed purchases of equities by foreign investors. Thus the current "stable disequilibrium" in the US has to break down at some point. Investors around the world can only hope that the adjustment to these serious imbalances is gradual. The implications for long-term returns in US equities, however, are not good.

Conversely, Japan is only now emerging from the Heisei Depression, which is the closest any investor would like to be to a 1920s-style depression. Investors can now look forward to the next decade of recovery, as no recovery from such serious damage is immediate or smooth. I recommend that investors maintain a "buy on weakness" posture for Japan, while keeping an eye on the big picture.

Biggest Topix Sectors are the Biggest Drag on the Index
For the calendar year to date (end April), Topix is down 1.7 percent, with the sell-off being led by automobiles, telecom, the electricals, the brokers and the banks -- that is, the sectors usually considered the leading edge of Japan's economy, and, with the exception of the brokers and the banks, the most internationally competitive.

Conversely, the leading sectors have been oil & coal, fishery/agriculture, mining, iron/steel, shipping, and warehousing/harbor - all about as "old Japan" as you can get.

The biggest performance problem for the Topix as a whole is the sheer size of the declining sectors, which in terms of total market capitalization account for no less than 43.9 percent of Topix market capitalization. On the other hand, the "old Japan" outperforming group accounts for a measly 4.5 percent of total market capital-ization - i.e., the Topix is not going anywhere significant as long as the largest sectors are having trouble maintaining positive momentum.

In addition, the JASDAQ is also stuck in a trading range mid-way in the peak-to-trough sell-off in 2004. I would be looking for out performance versus the Nikkei 225 developing as an initial indicator that the broader Japan stock indices are ready for a major break-out to the upside.

Japanese Institutions and Brokers Unloading Stock
Over the last couple of months, brokers have been liquidating their prop positions while domestic institutions continue to unload stock, particularly the trust banks (pension funds), even with the onset of the new fiscal year. Normally, Japanese institutional (pension) buying provides seasonal support for the Japanese market in April-June, but this is not present this year. Thus foreign and individual buying alone is not enough to support sustainable positive market momentum.

Former Large-Cap Shooting Stars - The Next Rally's Drivers?
For many years, two stocks were considered bellwethers for the Tokyo market -- Nomura Holdings and NTT. Both, however, have been suffering from a severe post-IT-bubble hangover since 2000.

Between 1998 and 2000 in the lead-up to the IT bubble, however, both stocks massively outperformed the Nikkei 225. Nomura moved essentially in lock step with the Nikkei 225 until 1999, and then exploded until the peak in 2000. The stock has been massively underperforming since.

Since 2002, the stock has twice tested ?1,200 downside resistance, and is currently moving to test this resistance level again. Cumulative trading volume is most concentrated between?1,800 - ?1,400, which means it will probably be difficult for the stock to break out of this range for the foreseeable future.

In the latter stages of the post-IT-bubble consolidation, the stock looked like it had renewed its close correlation with the Nikkei, but recently has again started to delink -- this time on the downside. Makes me wonder if this may be the last leg of the stock's underperformance to the Tokyo benchmark indices, similar to what occurred in 1999 before the massive IT bubble rally.

Prior to the IT bubble, NTT was also considered a market bellwether, but it had already delinked in 1997. While down over 75 percent from IT bubble highs, the stock has been bumping along ?400,000 resistance since.

The stock largely failed to participate in the rally from Q2 2003. Here again, however, support at ?400,000 is now well established. Like Nomura, the stock appears to be biding its time for bullish news to develop, as it is already 28 percent down from modest rebound highs in April of last year.

I believe that such large-cap, bombed-out stocks could be the drivers for the next major rally in Japanese stocks, and would be looking to begin accumulating such large caps on noticeable weakness, knowl-edgeable of the fact that as long as such large caps continue bumping along the bottom, there will be no substantial new highs in the Tokyo market. JI

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