Japanese equities plummeted on May 23, with the rate of decline reaching 6.9% (Figure 1). The causes of the plunge are not absolutely certain, but Citi thinks that many investors sensed an opportunity to take profits for now, as since the start of May the pace of share price gains was more rapid than the pace of yen weakening (Figure 2). Kenji Abe, equity strategist at Citi still thinks that Japanese equities are cheap noting:

“After sell-offs in October 2003 and May 2004, which were in a business-cycle upturn, the market started range-bound and then barreled higher, with the result that these were good buying opportunities. We think that conditions today are even better than they were then, given valuations and the boldness of current monetary easing.”

Below is the report on Japanese Equities presented without commentary except for this one question. Where the heck were all these ‘experts’ screaming Japanese equities are cheap before the 80% increase over the past few months (besides ValueWalk of course)?


Japanese Equities

Added to this were weak macro metrics from China, the rise in JGB yields, and debate on scaling back QE3 in the US, which we believe triggered the fall in share prices and a large volume of profit-taking selling. To this was added selling by momentum-focused investors, sparking the plunge in the market.

TOPIX and the dollar-yen rate

TOPIX and the Dollar-Yen Rate, A scatter plot

There have been just nine days since 2000 on which Japanese equities has lost more than 6.5% (Figure 3). Aside from May 23, they all occurred either in October 2008, approximately a month after the Lehman Brothers bankruptcy, or in March 2011, in the wake of the eastern Japan earthquake. Japanese equities turned in uninspired performances in the wake of the Lehman Brothers bankruptcy and the eastern Japan earthquake (Figure 4).

Japanese Equities Might Continue To Fall

However, it almost goes without saying that current conditions are completely different to those prevailing then. Neither global financial crises nor natural disasters of unprecedented scale are occurring. We feel it would be a mistake to argue that Japanese equities will continue to fall using 2008 and 2011 as examples.


Topix in the wake of the lehman brothers bankruptsy

Next, we look at the nine days since 2000 on which TOPIX has fallen more than 5% but less than 6.5% (Figure 5). The only occasions on which TOPIX fell by this amount in one day when, as now, the business cycle was in an upturn, occurred in October 2003 and May 2004. Subsequently, TOPIX did not experience a major correction and started in on a real rally in 2005, with the result that these were good opportunities to buy (Figure 6).

Topix has fallen

Topix from 2003 to 2005

We noted in Figures 1 and 2 how equities were advancing at a more rapid pace than the yen was weakening. With the recovery in the economy continuing, we forecast that the pace of equity gains will sooner or later exceed that of yen weakening, on earnings improvement brought on by factors other than the weak yen and rising investor risk appetites. However, we think it is a little too early in the day for this to happen.

Japanese Equities: Comparison with 2003 and 2004

We think the significant decline on May 23 presents a good opportunity to buy, as did major declines in October 2003 and May 2005. We therefore compare the three periods in terms of macroeconomic conditions, corporate earnings, and valuations.

Japanese Equities: Economic conditions

The global economy was strong in 2003 and 2004, and Japan’s economy was going through a period of export-led expansion (Figure 7). Right now the Japanese economy is expanding, driven by a weaker yen and higher asset prices stemming
from “Abenomics” (for more, please see our May 15 report Japan Equity Strategist – Abenomics impact to become clearer). We believe yen weakness will mean higher export volume moving forward, so on this point the periods look similar. In addition, inventories have been reduced of late so we think the odds of a recession are lower now than in 2003 and 2004.

Japanese Equities: Corporate earnings

FY3/13 RP fell in between the levels seen in FY3/04 and FY3/05, and we expect RP to increase in FY3/14 (Figure 8). Current conditions thus look like both October 2003 and May 2004 not only in terms of RP level but in that earnings are in a period of recovery.

Industrial production and real exports

Corporate Earnings for tse 1 names

Japanese Equities: Valuations

PER and CAPE based on FY3/14 estimates are lower than in October 2003 and May 2004, so equities currently look relatively undervalued (Figure 9 and 10).

PER for TSE names


Japanese Equities: Investment in Japanese equities by foreign investors

Foreign investors were buying Japanese equities in 2003 and 2004, as they are now. Since November 2012 foreign investors have been buying up Japanese equities at a somewhat faster pace than they did in the bull market that started in April 2003 (Figure 11).

Japanese Equities: Sentiment among Japanese institutional investors

If we measure sentiment at Japanese institutional investors by the percentage of equities in their portfolios, we see that right now the equity weighting is higher than it was in October 2003 or May 2004 (Figure 12), suggesting sentiment is better.

cumulative investments in japanese equities

equity weighting index for japanese insitutional

Japanese Equities: Quality versus Risk

In our November 7, 2012 report Japan Equity Strategist – Will the shift from Quality to Risk names continue? we noted that the relative positioning of the Quality index relative to the Risk index was the highest it had been since 1995. Thereafter the Risk index rose sharply and the Quality index fell, so relative positioning returned to the average since 1995. In both 2003 and 2004 the relative positioning of the Quality index declined significantly (Figure 13).

In this sense current conditions look like 2003 and 2004. However, relative positioning is higher at the moment, and we see scope for the Risk index to continue outperforming the Quality index.

Japanese Equities: Revision Index

Since January 2013 the Revision Index has remained in positive territory, meaning there have been more upward revisions than downward revisions (Figure 14). The Revision Index was also in positive territory in October 2003 and May 2004. In this sense the three time periods look