There is an ongoing debate about the character of the current bull market in US stocks. There is a contingent that believes that this is a new secular bull market, one that is driven by factors that will last many years or decades. The counter to that is that this is merely a cyclical bull market in the context of the secular bear market that started in 2000. If you’ve been reading these weekly missives for any length of time you won’t be surprised to learn that I don’t hew to the secular view. US stocks are not now and were not at the beginning of this move cheap enough in my opinion to support a secular bull market thesis. They have only gotten more expensive over the last couple of years and now stand at valuations that are only exceeded by a couple of times in history, namely 1929 and 2000. Shiller’s P/E, prices to sales ratio, price to book value, market cap to GDP, price to cash flow, take your choice, all show a market very richly valued. That doesn’t, of course, mean they can’t go higher from here but just realize that we are well into greater fool territory with US stocks. Absent a major shift higher in US growth – something I see no evidence of – there is little reason to expect big returns from US stocks over the next decade.
I have some pretty good company in that assessment from Robert Shiller to Jeremy Grantham and many others for whom I have a great deal of respect. This week Shiller intimated that he is moving some of his personal investments to Europe due to high US valuations. Specifically, he said that he had already invested in some stock indexes in Spain and Italy and was considering other European investments. It is nice to have a Nobel Prize winner on my side and Europe is certainly cheaper than the US, but I find it hard to get excited about Italy, Spain or any of the developed European markets until they embrace more fundamental changes. In the short term, there might be some upside assuming Greece doesn’t upset the markets, but longer term Europe’s structural problems make it a tough place to find growth. And I see zero appetite for the types of reforms they really need.
A friend asked me this question earlier this week: If you were investing for growth over the next 20 years and had to choose only one geographic area, what would it be? Well, it could be the US but you really have to pay up for that potential growth and current economic policy certainly doesn’t help. With a high corporate tax rate, an onerous regulatory environment and a populist tilt to the political debate emphasizing equality over growth the US is not, in my opinion, moving in the right direction. Latin America, Australia and Canada are all resource based and therefore more cyclical than secular by nature. Africa probably has a lot of potential but governance is awful and doesn’t seem to be improving. Europe is resisting structural reform at all costs. By process of elimination if nothing else, that leaves Asia.
Asia has, by far, the fastest growth in the world with India and China battling it out for the best annualized growth rate. Emerging Asian growth, even in this slow growth world, is expected to average 5 to 7% in 2015 (depending on the country) and that is after a recent downgrade in expectations. China, even with all its problems is likely to continue growing at mid-single digit rates and India’s economy is recovering with the new administration. Vietnam, Malaysia and Cambodia are well positioned to continue growing their export economies. Indonesia, despite being negatively affected by lower commodity prices, is expected to grow at over 5% this year. The more mature economies such as Korea, Taiwan and Hong Kong are all expected to grow at around 3% this year. There are, of course, risks to those expectations – specifically a US growth slowdown – but there seems little doubt that if you are looking for growth you are more likely to find it in Asia than anywhere else.
You might have noticed that there is one country I didn’t mention in that paragraph – Japan. And that, yes, is the market to which the title of this article refers, where I think we might be seeing the beginnings of a secular bull market. I know, I know, Japan is a bug in search of a windshield according to John Mauldin and some other smart people, but I think there are major changes underway there that will benefit Japanese companies for years and maybe decades. We made our first allocation to Japan (via DXJ) in the summer of 2012 before Abe was elected and the BOJ cranked up the printing press so we aren’t new to the Japan trade but we think it has much more to go.
Why do I think Japan is entering a secular bull market rather than just another of the cyclical variety that has been typical for the last 20 years? First and foremost for investors like me who care about getting some value for our hard earned dollars is that Japan’s stock market, even after the rally so far, is still cheap. Not just cheap compared to the US or the rest of the world but absolutely cheap. Based on forward estimates (not the best valuation technique I know but analysts have been underestimating Japanese earnings growth since the bull market started) the Nikkei trades at just 13 times next year’s earnings. The broader TOPIX trades for about 1.3 times book value which is way up from 0.8 before the rally but a heck of a lot less than the US ratio of 2.7.
Second and probably more important is that I believe there is a major change underway in Japan’s corporate culture. The Abe administration can even claim some credit for the change with their emphasis on ROE, earnings and corporate governance in the new JPX-Nikkei 400 index which they had a hand in formulating. The index was designed to prod the government pension fund to allocate more of their assets to Japanese stocks as they invest more in equities generally. Japanese companies have traditionally been managed in ways that have curtailed ROE. They operated to maximize market share and hoarded cash to buffer against bad times which have been frequent in Japan the last 25 years. Everyone talks about US companies hoarding cash but as of the 3rd quarter last year Japanese companies were holding $2.17 trillion in cash (and that is after the Yen devaluation), roughly 60% more than US companies – in a smaller economy. Companies are chosen for the new index based on ROE and operating profits which make up 80% of the criteria.
Corporate governance is also involved in the selection process and companies are changing their ways to try and gain admittance to the index. Stock buybacks and dividends are rising. Independent directors, encouraged but not required for inclusion in the index, are being hired. Companies are changing in an effort to be included assuming that being in the index will mean higher share prices and a reduced cost of capital. Just this week Sony announced an ambitious plan to raise operating profits 25 fold by 2018. They are targeting an ROE of 10%, concentrating on profits rather than volume, placing divisions in separate structures and holding division managers accountable for profitability. That might just sound like good business practice but it is a sea change in Japan.
Returns on equity and profit margins in Japan are less than half that of the S&P 500 and among the lowest in the world. There is a lot of room for improvement in corporate performance and it appears that corporate Japan is finally ready to make the effort. A lot depends on Abe’s reforms and I, like many others, have been disappointed with the pace of change. But the changes are taking place and while I am a bit suspect of the BOJ’s role with QE, I am more hopeful about the change in corporate culture. Other reforms will take time but they have already announced a cut in the corporate tax this year and another is planned next year. The changes are small and incremental but at least they are moving in the right direction, contrary to the US. As for the BOJ, I suspect that at least internally, they are targeting specific levels of the Yen and will stabilize its value at some point to ensure capital outflows don’t derail the recovery.
Another factor working in Japan’s favor is the current inward focus of China. China is not well liked by its neighbors – feared is probably a more accurate description – but is now focused on rebalancing their economy to a more domestic growth orientation. As China concentrates on cleaning up after their credit bubble, Japan is positioned to gain influence in the rest of Asia. Their banks are well capitalized and positioned to pick up the slack from Chinese banks that are facing loan losses and potential recapitalization. There has been a lot of worry about Abe’s aggressive stance on foreign policy but I see it as part of the economic reform plan. Abe may talk tough but all he’s trying to do is regain some of the influence Japan has lost to China over the last two decades. It is a delicate balance between showing the rest of Asia he has their back while not doing so much that it raises China’s hackles and cuts off business opportunities there for Japanese companies. So far, I’d say he’s done a pretty good job of it.
From a technical perspective the Nikkei is now trading at a 15 year high and while that might give you pause, it is also now above a downtrend line that had capped the market for 20 years. At 18300 the index is still less than half the all time high of 38,915 set back in late 1989. There will be corrections along the way, as there are in all bull markets, but the Nikkei looks to me to have finally broken out of its long stagnation. As everyone debates whether the US stock market is in another secular bull – near an all time high valuation level – there is one developing in Japan right before our eyes at more than reasonable valuations that almost no one believes is possible. Just as, I would point out, few believed a secular bull market was possible in the US in 1982.
The risks to the bull thesis are, in my opinion, not in Japan but in the rest of the world. Japan has devalued the Yen to increase their export competitiveness but so far Japanese companies have focused on reaping larger Yen profits. At some point they may shift to seeking a larger share of the global market but that is probably still a ways off. In the meantime, growth outside Japan and specifically in the US, is critical to the success of the Japanese reforms. They don’t need the US to boom but steady global growth and corporate reforms should ensure continued earnings gains. A US recession would definitely be a setback to the Japanese re-emergence but I don’t think it changes the secular bull thesis. The sun is rising on Japan again.
Note 1: I know there are other considerations such as demographics and the level of government debt but this is too long already so I’ll have to address those in a future article.
Note 2: Alhambra runs an International Value model portfolio. If you would like information about this portfolio contact me per the information below.
Disclosure: Alhambra and/or its clients and employees have positions in DXJ, AAXJ, SNE, TM, HMC, MTU, SFTBY and KMTUY.
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