MW-36 -- Do You Believe or Are You Just Greedy?

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 36
Tuesday, July 22, 2003

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Viewpoint: Do You Believe or Are You Just Greedy?

The Bottom Line:

o At the beginning of March, investors were fearful of just
about everything, and the US was going to another war in the
Gulf. Then, Money Watch was pretty confident that history was
on the market's side and the markets would rally as blood was
running in the streets. History was on the market's side. But
the dramatic turnaround in investor sentiment is now sending
up warning flags. Investor sentiment is rising even fast than
stock prices. A few months ago, "Japan passing" was the thing.
Now, there are suggestions that this is the beginning of the
end of deflation and the Heisei Malaise.

o After having had a chance to more closely examine the
unprecedented surge in Japan trading volumes, Money Watch
believes it is caused by day traders, hedge funds and, to a
lesser extent, some switching from bonds to equities by
domestic institutions. This suggests there is more greed
involved than real belief in a sustainable recovery. Between
the April 28 low and July 4, individual investors and day
traders making up to 290 trades per day (or over one trade per
minute!) accounted for 44 percent of all trading volume, but
only 26.3 percent of trading value. In other words, they were
momentum trading the penny stocks like crazy. The hedge funds,
on the other hand, accounted for up to one-half of the foreign

o The Nikkei 225 is back to where it was when Heizo "God of
Poverty" Takenaka assumed control of the FSA, which means the
"hard landing" discount has reversed following the benign
bailout of Resona Holdings. But as Alan Greenspan pointed out,
Japan's economy and financial sector remains in "difficult
straits." With the pressure off from falling stock prices, the
FSA can again turn up the heat on the banks to clean up their
balance sheets. Talk of recovery also has the Koizumi
administration trimming public works expenditures for next
year's budget, and the Bank of Japan has slowed its purchase
of stocks directly from the banks. "Normalization" of interest
rates (ostensibly on the belief that the Heisei Malaise is
indeed ending) to the 2-3 percent level at this point would be
particularly problematic from the NPL and government funding

o Seasonally speaking, the "typical" (average of the past 13
years) trading year during the Heisei Malaise has the stock
market trading higher during the first half of the year and
then selling off in the second half in a classic "sell in May
and go away" pattern. Historical trading patterns would
suggest that Japan market gains will become more difficult
throughout the second half of the year.

o Moreover, the bull case for Japanese equities and indeed
equities around the world is predicated on a US recovery and a
secular trough in US stock prices. In addition, relative
performance versus the US is predicated on continued declines
in the US dollar and lower relative expected returns for US
equities. Thus the very same factors that now make Japan an
attractive relative play are hostage to the expectations of a
US economic recovery.

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Viewpoint: Do You Believe or Are You Just Greedy?

Investor sentiment has undergone a substantial shift since early
March. In January 2000, a decade-long "party" ended, with the Nasdaq
Composite (NAZ) peaking at 4,073 at the height of "new economy" mania
and investor greed. As the NAZ plunged over the next two years to
1,109, the US officially entered a recession in March 2001. But the
real defining moment in the evolution from greed to fear was September
11, 2001. The shocking terrorist attacks in New York made it painfully
clear to all Americans that they too were not immune from a growing
plague of global terrorism.

Thereafter, it seemed to just get worse and worse. heroes
became dot.bombs, and "new economy" stalwarts like Enron and Worldcom
spectacularly crashed and burned. All the while, the drums of war were
beating, implying potential interruption of global oil supplies. As
the US was shipping troops for battle in the Middle East, the medical
community threw another grenade at investor confidence by announcing
that a virulent new disease called SARS (Severe Acute Respiratory
Syndrome) was developing into a global crisis.

As investor fear continued to build amidst sinking economic activity
worldwide, and in the US in particular, the US Federal Reserve
aggressively moved to lower interest rates and ease monetary
conditions, fueling a bull market in bonds. At the same time, falling
interest rates, a crashing dollar and investor fear revived the long
moribund gold market, the buying of which was also supported by the
increasing fear that Japan's deflation poltergeist was on the verge of
spreading into Asia and the major developed economies.

The sum of all these fears was the equity market lows that were hit in
early March, just as CNN was broadcasting live pictures of US assault
tanks racing across the Iraqi desert, a year and four months after
November 2001, the date that the US National Bureau of Economic
Research belatedly declared was the trough of the US recession. The US
recession had ostensibly lasted only eight months, less than the
average recession in the US since World War II.

The secular lows in both the Dow Jones industrial average and the
Nasdaq Composite were made in October 2002, almost a full year after
the official end of the US recession. While cumulative volumes on the
Dow Jones were noticeably light at these lows, the opposite is true
for the Nasdaq, where the bulk of the cumulative trading volume since
late 2001 has occurred below 2,000.

Essentially no stock market participant (be it stock brokers,
investment bankers, M&A specialists, accountants, corporate
management, mutual fund managers, pension fund managers, the ruling
administration, the central bank, journalists reporting on the stock
market or school teachers with 401Ks) really wants falling stock
prices. And while textbooks say that stock prices "read" future
economic activity, one could argue just as convincingly that the crash
of the Nasdaq in 2000 led to the US economic recession from March

But to really determine whether the current US rally is sustainable,
or merely a bout of collective wishful thinking, one has to filter out
the hype and get to the meat of the issue.

1. Business sentiment is improving in the US among major
corporations. A recent US Commerce Department survey of 117 senior
executives shows they view the possibility of a new recession as
extremely unlikely. But while US business sentiment has brightened,
few of the executives polled in the most recent survey planned to
increase capital expenditures, and 42 percent said their work forces
would shrink over the next six months. More than 2.3 million jobs have
already disappeared in the US, making the hiring slump the worst in 20
years and the longest in more than 60 years. Since the US economy
began weakening, chief executives have been correctly predicting that
the US economy would struggle to overcome the excesses in capital
expenditures during the IT bubble, and they have been proven more
right than the Fed or Wall Street so far.

2. But the Fed has repeatedly been too sanguine about a US
recovery. Alan Greenspan has often said that a healthy recovery was
just on the horizon, only to be proven too optimistic, while
nevertheless repeating the same prediction again a few months later.
In an Asahi Shimbun interview with Laurence Mayer of the Center for
Strategic and International Studies and a former board member of the
Fed, he repeated the bull's scenario (which is now being discounted in
US stock prices) that US GDP will rebound by 4-4.5 percent in the
second half of 2003 versus the first half. The Fed's own FOMC
apparently expects robust growth next year and stable inflation, and
that's what upset the US treasuries teapot despite Greenspan's
testimony that the Fed would keep US monetary policy highly
accommodative for as long as needed in order to ensure satisfactory US
economic performance.

3. What happened to the deflation scare? Only weeks ago, the Fed
and US economists and strategists were publicly fretting about
deflation, ostensibly because of a combination of noticeable gaps
between current and potential GDP growth worldwide and intense global
competition among companies. The Fed is depending on a stock market
rally, low interest rates and the Bush administration's tax cuts to
boost business confidence enough to get capital expenditures going
again. But in terms of money supply and credit, the Fed is actually
waiting to see if deflation is really going to hit the US before
turning up, as Bernanke calls it, "the electronic printing press." In
reality, the annual percentage change in money supply is decreasing,
and the Fed will need to ramp up money supply growth to provide fuel
to keep growing demand for money in the real economy from strangling
the stock market rally. In either case, a correction in the US stock
market is inevitable as the stock market transitions from an
excess-liquidity driven rally to an earnings driven
rally amid rising interest rates.

4. No secular bull market in US history has begun from current
valuation levels. It is unprecedented in US market history that a
major bull market begin with trailing P/E multiples over 30X earnings,
as is the case now. Major market troughs in the past have started with
valuations at least 60 percent lower. This implies that a) potential
equity returns will at least be much more limited than past
recoveries, or b) the current rally in the US is a false dawn.

5. What happened to the secular dollar decline scenario? There is
one more problem, and that is the so-called secular decline in the US
dollar. However, if the secular lows seen in the Nasdaq in October
last year are indeed valid, a further dollar sell-off of the degree
already seen is unlikely, particularly as the economic recovery
ostensibly supporting the rally will also alleviate pressure on the
dollar. Technically, however, the dollar still has a long way to go.

The US situation is different from Japan's. However, Money Watch has
always believed that the risk of deflation in the US was overblown.
The US case is different from Japan's case in two key respects: a) The
banking system is viable and relatively healthy, while Japan's is
effectively bankrupt but for one or two banks, and b) US property
prices have held up through the bursting of the stock market bubble,
whereas Japanese property prices crashed along with stock prices.

The US Bottom Line
Where does that leave the US? With a high probability that the secular
lows have already been seen in the US market, but with
less-than-average potential equity returns going into the recovery.
While gold has sold off noticeably, it is finding tentative
support at its 200-day moving average, while the dollar's recovery has
yet to breach its 200-day moving average, which remains in a steep
decline. From here, the probability of an extended correction as the
equity market shifts from being driven by excess liquidity to earnings
is directly correlated to investor confidence in the strength of the
expected recovery, on how violent a reaction this provokes in the bond
market and on how supportive it will be for the dollar against the yen
and the euro.

Japan's latest tankan quarterly business survey revealed a surprising
improvement in business sentiment among Japanese executives and has
led to modest upward revisions in consensus GDP forecasts. The index
of sentiment among large manufacturers in the latest tankan showed
better-than-expected improvement, but the closely watched index
remained in negative territory for the 10th consecutive quarter -- the
minus figure continued to indicate that a majority of firms believe
conditions are still unfavorable. Like the US, the improvement in
sentiment in Japan is contingent on a recovery in production and
cyclical growth in the second half of 2003, and ostensibly driven by
overseas demand, as was recently indicated by BOJ governor Fukui's
recent remarks.

The problem with looking at "fundamental" data to judge a turn in the
equity market is that stock prices are a leading indicator. In other
words, looking for fundamental data to substantiate the initial upturn
in stock prices is like trying to drive a car forward by looking in
the rearview mirror. Stock prices lead industrial production by up to
12 months and corporate profits as well as most everything else by at
least three to six months. While the composite ratio
(coincidental/lagging composite economic indicator ratio) does have a
long enough lead time to be useful as a reality check for stock
prices, and the recent uptick in this indicator does offer
encouragement, whether the improvement continues remains to be seen.

Foreign investors are recently piling into not only Japanese stocks
but also Asian stocks in general. The Merrill Lynch survey of 293 fund
managers managing $742 billion in assets shows that the difference
between the percentage of fund managers planning to be overweight in
Japan during the next 12 months rose from minus 23 in May to plus 5 in
July. But as the Wall Street Journal pointed out, the same factors
that currently make Japan relatively attractive to foreign investors
are hostage to expectations of a US recovery.

Suggestions that the unprecedented surge in trading volumes on the
Tokyo Stock Exchange indicates an end to deflation in Japan should be
taken with a large pinch of salt, in Money Watch's view. Foreign
investors bridged the gap between "Japan passing" and "Japan again"
not by embracing a Japan "revival" scenario, but by merely
reappraising what had become an overly pessimistic view of the
bottom-up picture in Japan. Justification for this less pessimistic
view was the progress in restructuring at the grass-roots level,
"cheap" valuations in the Japanese market vis-・vis the US and a more
sanguine view of the risks in Japan's banking system following the
bailout of Resona Bank.

One needs to remember, however, that the apparently attractive
prospective price-earnings ratio (PER) for the Nikkei and Topix is
predicated on the major banks actually reporting a profit. Last year,
losses at the banks completely erased profits in other sectors and
rendered the market's PER meaningless. This has happened all too often
during the Heisei Malaise.

As Alan Greenspan pointed out in his recent Congressional testimony,
Japan's economy and financial sector remain in "difficult straits."
How difficult was recently underscored by the passage of a law
allowing life insurers to break contracts and lower the amount of
yields they had promised to pay policyholders. The Japanese life
insurance market is one of the largest in the world, with policies
outstanding worth some $10.5 trillion. Insurance policies are a major
savings vehicle for Japanese individuals, and life insurers are major
holders of Japanese equities and bonds. But the dangerously high level
of cross gearing among the life insurers and the banks has been
identified as a source of systemic risk not only by credit agencies,
but also by the IMF. In response to the passage of the law, Standard &
Poor's immediately issued a report stating that it would consider any
reduction of yields (supposedly guaranteed) as a default.

Also, the issue of cross gearing between the life insurers and the
banks is serious, as is the issue of deferred tax assets. Resona is
not the only Japanese bank with "vapor" capital.

With the heat off from falling stock prices, the Financial Services
Agency (FSA) is again upping the pressure on the banks to clean up
their balance sheets. The banks are bracing for orders to improve
their earnings that the FSA is expected to issue as early as this
month. The orders are expected to hit 15 banks that received public
funds, including five major banks that booked net losses in fiscal
2002. Having survived a no-confidence vote in the Diet, Takenaka is
also expected to take a tough stance on the banks when they prepare
their earnings results for the fiscal half ending Sept. 30 and the
full-year term through March 31, 2004. The banks that have received
public funds in the two previous infusions of taxpayer money have
failed to meet the earnings targets stipulated in their revitalization
plans. The Financial Revival Plan introduced by Takenaka provided for
the government to convert preferred shares that it acquired in
exchange for public fund injections into common shares if a bank
forgoes dividend payments for two years in a row. The FSA can ask top
executives to step down if they fail to achieve earnings goals
included in the plans.

After the passage of the Sarbanes-Oxley Act in the US, Japanese audit
firms have come under increasing pressure to toughen their audit
standards. The Nikkei recently surveyed Japanese audit firms and got
responses from 37, which audit over 70 percent of all listed Japanese
companies. Some 68 percent of these firms said their auditing of
corporate accounts for the year ended March 2003 was more stringent,
because new auditing standards were introduced. The greatest
percentage, 80 percent, cited deferred tax assets as an item for which
they toughened their audits. Moreover, 49 percent replied that
auditors tend to come up with different valuations of deferred tax
assets. As was the case with Resona, there are other Japanese banks
that could be declared insolvent with the stroke of an auditors' pen.

In terms of the Japanese market's seasonality during the 13-year
Heisei Malaise, the old adage of "sell in May and go away" has
generally been a profitable trade. During the last 13 years, yearly
market highs have been hit during the first and second quarters of the
calendar year in 10 of 13 years, versus only three times in the second
half of the year. Conversely, annual lows have been hit in 11 of 13
years during the third and fourth quarters of the calendar year, with
no lows being hit during the second quarter of all 13 years.

Thus a "typical" year is where annual highs are hit during the second
quarter of the calendar year, ostensibly because domestic
institutions, flush with new cash allocations for the fiscal year
ending March, allocate the bulk of their investments for the coming
year during the first quarter. Now that the Japanese market has neared
10,000 on the Nikkei 225 once and failed to hold, and the "Takenaka"
discount has been redressed, Money Watch sees a better-than-even
probability that annual market highs for the 2003 trading year have
already been seen.

Foreign investors piling into Japanese equities have reignited retail
(day trader) demand in Japan, which has been extremely active during
the past two months. Another factor that supported this trading was
the rescue of Resona Bank, which fostered the conjecture that many
penny stocks being priced for bankruptcy would also be saved. In terms
of trading volumes, individual investors accounted for 44 percent of
trading volume between April 28 and July 4, with discount brokerage
king Matsui Securities reporting that these extremely active
individual traders made up to 290 trades per day, or over one trade a

How the more sanguine view of bankruptcy risk behind the current rally
has affected trading is apparent in the percentage of recovery so far
seen in Nikkei sectors from the IT peak of 20,833.21 on the Nikkei 225
on April 12, 2000 to the recent low of 7,603.76 on April 28, 2003.
Four sectors -- shipbuilding, nonlife insurance, transportation
equipment and automobiles -- have completely recovered, while the
darlings of the IT bubble -- telecom services, services (software),
electricals, precisions and ceramics -- are still more than 70 percent
below these peaks. Banks, which also have bounced nicely following the
Resona rescue, are at a mere 15 percent of their April 2000 levels.

Financial stocks dominate the top 20 gainers from the April 28 low.
UFJ has surged 190 percent, Mizuho Financial Group 113 percent, Mitsui
Sumitomo Financial Group 89 percent, Resona Holdings 89 percent,
Mizuho Trust 88 percent and Mitsubishi Tokyo Financial Group 67
percent. The other top gainers were those caught up in the prior IT
bubble, which so far have managed to recover only a fraction of their
highs during that period. Softbank has surged 137 percent, Furukawa
Electric 136 percent, NEC 130 percent, Fujitsu 98 percent, Japan
Oracle 89 percent, TDK 68 percent, Trend Micro 67 percent, NTT Data 66
percent and Advantest 66 percent. This looks more like a "dead cat
bounce" relative momentum play than a real "I believe" fundamental
recovery in Japanese equities.

The catalyst for virtually every rally in the Heisei bear market has
been foreign investors. When stocks rally, the government, the
Japanese investment community and Japanese pension funds breathe a
collective sigh of relief. Armageddon has been avoided yet again.
Moreover, the tendency is to lapse into the usual "Heisei stupor" and
to put off needed reforms. This time, the good news is that Prime
Minister Koizumi and Takenaka don't intend to let that happen on their
watch, and as long as the Koizumi administration retains power, we are
likely to see slow but steady progress in the reforms that will
eventually form the basis for an escape from the Heisei Malaise.

In their arguments for "Japan again," investors often overstate the
positives and understate the still substantial structural problems.
The asset deflation Japan has suffered over the past decade exceeds,
by a factor of two, even the US$7 trillion that the US markets lost
after the collapse of the technology and telecoms bubble during the
last three years. Japanese asset prices are inextricably linked to the
health of banks, life insurance companies and pension funds in Japan,
all of which are technically bankrupt now, but which get a stay of
execution when stocks rally.

In order to rescue these institutions and to redeem the massive
amounts of debt among Japanese banks and business corporations,
massive infusions of public capital are probably needed unless the
stock market and property prices somehow miraculously recover by
themselves. Since the government bond market is saturated, the only
sources of such funds will be the Bank of Japan, which will have to
print huge amounts of new money, or the government may have to resort
to printing its own currency.

Thus while Japan has become the "flavor of the week," investors do
need to keep in mind that the rally does nothing to solve Japan's
still serious structural issues, and that these issues will be back.

-- Darrel Whitten

"What You Should Read After Irrational Exuberance"
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Written by Darrel Whitten

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