Taking Profits on Japan

Northlake clients have owned a position in Japan via the iShares MSCI Japan Index (EWJ) for over two years. Until yesterday that is. At the open, I sold the entire position. My opinion that Japan is exiting a multi-decade economic and stock market slump has not changed. Rather, with the market having been so strong, seasonals turning negative, and most client accounts being fully invested, I felt it was prudent to raise some cash.

With Disney (DIS) pending after the close, all of the individual stocks held by Northlake clients have reported outstanding quarterly earnings and guidance was either increased or a bias for higher guidance was implied (see my recent coverage of earnings calls for AAPL, CETV, NIHD, RG, and RGC). With increased confidence in the outlook for these stocks and their ability to bounce back from any market related weakness, I feel that clients are in good shape holding these positions even as I desire to raise cash. Away from individual stocks, other client holdings were EWJ and the money dedicated to Northlake's Market Cap and Style models. The allocation toward the models is permanent as part of a relative performance strategy, so that left me with Japan as a possible sale....

Three things convinced me to pull the trigger and sell. First, Japan has been sharply lagging the global market rally. This makes me concerned that if the global rally entered a pullback, Japan would lead to the downside. Second, when I thought about why Japan has been lagging I realized that it was due to the risk of slowing US economic growth and its impact on the country's export driven economy. In my view, the primary risk to US stocks is that the economy slows further and faster than the consensus expects. I don't know if that will happen but if it does, it reinforces my view that EWJ was a good place to raise cash. Finally, another meaningful risk to the stock market is China. As we saw in February, global markets are very sensitive to dislocations in China. Japan's turnaround has been significantly aided by its exposure to China and if another hiccup were to occur Japanese stocks would likely suffer relatively more damage.

Client cash positions now average about 10% which is in the middle of the 3-15% range I use in most client accounts. Given how far the market has come, I thought it was time to ring the register and take some gains. Given my view on what might lead the market to suffer a sharp pullback, EWJ seemed like the best choice for raising cash.

Japan's GDP Report Supports Bull Case

Earlier this week, the 1Q06 GDP report in Japan was revised. Several statistics noted in this Bloomberg article article discussing the report support my bull case on Japan.

GDP grew by a healthy 3.1% in 1Q06, revised upward from 1.9%. Corporate spending rose at its second fastest rate since 1990. Machinery orders were up almost 11%. Inventory investment rose sharply. Bank lending has risen for four straight months. These datapoints all indicate that corporate confidence in continuing GDP growth is high. Modestly improving consumer spending shows that consumer confidence also supports future growth.

As is the rest of the world, inflation is up in Japan....

The GDP report showed prices rising 3.3%. In the US and Europe, inflation is big worry for investors. Japan is not immune to inflation risks but given that the country experienced deflation for the most of the last 15 years, the pickup in consumer prices is less of a problem.

Lastly, I have to say I found the fact that the current economic expansion in Japan is the second longest in the country's post-World War II history to be surprising. In fact, with GDP growth picking up to 3%, it has now reached its highest level in about nine years.

The bull case for Japanese stocks is if economic growth can hold at this new and higher level, operating leverage will kick in and drive corporate profit growth. Additionally, moving from deflation to inflation can help the Japanese economy as long as inflation does not accelerate too far. Put these two ideas together and the pickup in GDP growth can be self-fulfilling, extending the current recovery in GDP and putting it on plane that supports higher stock prices.

Increasing Positions in Japan

After raising cash and reducing risk exposure by selling positions in the Central Europe and Russia Fund (CEE), (down a stunning 20% since the sale last Monday morning), reducing some holdings of the Russell 2000 (IWM), and swapping from small and mid caps to large caps, I decided to put a little money back to work late last week.

My vehicle of choice was iShares MSCI Japan (EWJ)....

The Nikkei has been destroyed of late. EWJ had fallen 16% since May 10th and 9% in just the first four days of last week. Despite the thrashing, I believe the long-term fundamentals in Japan remain largely the same as they were when the market was rallying to multiyear highs – renewed economic growth, healthier bank balance sheets, renewed loan demand, and long-term benefits from growth in China and other smaller Asian market economies. I am moving toward making Japan a 4-5% across all client portfolios, up from prior positions closer to 3%.

The Nikkei has rebounded a little since the purchase including some gains today following the release of an updated 1Q06 GDP report for Japan. Several statistics noted in the Bloomberg article support my bull case on Japan. GDP grew by a healthy 3.1% in 1Q06, revised upward from 1.9%. Corporate spending rose at its second fastest rate since 1990. Machinery orders were up almost 11%. Inventory investment rose sharply. Bank lending has risen for four straight months. These datapoints all indicate that corporate confidence in continuing GDP growth is high. Modestly improving consumer spending shows that consumer confidence also supports future growth. Inflation is up in Japan, the GDP report showed prices rising 3.3%. In the US and Europe, inflation is big worry for investors. Japan is not immune to inflation risks but given that the country experienced deflation for the most of the last 15 years, the pickup in consumer prices is less of a problem.

If my timing was bad and the Nikkei continues to melt, I expect I'll average into the position further unless the current stock market crisis morphs into a global economic dislocation. I remain of the belief that this will not be the case. I think investor confidence has been fragile and once the market took a couple beatings, the shallowness of bullish conviction was quickly revealed. The stagflation (weak employment, falling GDP growth, and rising inflation) scare is just that -- a scare -- and a scared market is something different than a bear market.

Japan On the Mend: Going Long

Shortly after the open Thursday, I completed the purchase of a position in the Japanese stock market across all client accounts. The purchase was completed through the exchange traded fund that tracks the major Japanese market index. The ticker symbol is EWJ. Certain clients had owned Japan previously as part of a group of ETFs designed to broadly track global market trends. Those positions are in the buy and hold mode. The most recent purchase is based on the assumption that excellent profits are available over the next six to twelve months....

The Demise of Deflation

Basically, I believe that Japan is exiting a multi-decade period of deflation. The very factors that are worrying U.S. investors appear to be positives for Japan. Inflation for us may very well be reflation for the Japanese. Fundamentals in the Japanese economy are improving with interest rates and real estate pricing rising for the first time in many years. Japanese banks have cleaned up their balance sheets and liquidity now exists throughout the economy for a sustained growth spurt in GDP.

Reform and Growth

I also like the outcome of the recent election which seems to give impetus to a growing reform movement in Japan. It seems like the Japanese government is becoming more responsive to its citizens right as the economy is beginning to accelerate. The September vote will allow Prime Minister Koizumi to implement the reform of the $3 trillion Japan Post. This savings giant will be split into four entities in 2007 in the hope of stimulating competition.

Simultaneous political and economic reform sets up a virtuous circle of improving consumer and business confidence and possibly less government interference in the economy setting the stage gor a long period of improving economic growth. Dare I say, it reminds somewhat of the situation from 1992 to 2000 during the Clinton Administration.

In addition, this week Japan got a further boost from the weakness in oil prices. Japan is a major importer of oil and I think any let up in energy prices removes a potential roadblock to the economic recovery.

Risks

Obviously a global market decline or economic meltdown are ever-present risks. More specific to Japan, however, is the country’s exposure to oil prices and the Chinese economy. A further spike in oil could derail Japan’s recovery, as could an unexpected slowdown in China, which drives much of the GDP growth throughout Asia and which specifically benefits Japan.

Building The Position

Most clients have about 70% of the position I ultimately would like to own in Japan. I am a little fearful of U.S. stocks for the next two to three weeks. If that fear proves correct, the Nikkei is not likely to be able to buck the trend. Should my fears subside or should stock prices pullback further, I plan to finish off the position with the Japan Smaller Cap Fund (JOF) to add some beta to the call.