Japanese Equities or specifically the TOPIX lost 6.9% on May 23 amid concern about China’s economic outlook. Prior to the sharp drop, the market had been rising at an extraordinary pace (, partly because Japanese stocks have been undervalued. By May 20, TOPIX was 44.1% above the 200-day moving average, which is the widest spread in about 60 years (since February 1953). Chisato Haganuma Mitsubishi UFJ thinks the stock market has been largely driven by liquidity factors and that a rally with this momentum was due for a correction, he states in a new report. Other factors have played a role and Chisato discusses some other reasons below in this new report from the Japanese research firm.
We see several similarities between the current market rally and 1986, when the so-called “triple merits” (a strong yen, falling interest rates, and a decline in the oil price) were key market drivers. In fall 2012, some market observers believed Japanese stocks had lower P/E valuations than their US and European counterparts because of the structural issues behind the country’s shrinking and ageing population and its enormous government debt. Rising stock prices fuelled expectations of further increases, so when share prices fell this undermined investor confidence. In the current context, we think volatility has been exacerbated by the lack of reliable valuations and the increase in passive and index-linked foreign investment in Japanese equities.
We still expect Japanese equities to gain ground over the medium term as company earnings improve, but based on FY13 forward P/E ratios we do not think Japanese equities are as undervalued as they have been, relative to the other major stock markets in developed economies. Tokyo’s stock market could continue to adjust in the short term, until there is greater investor confidence in a major improvement in company earnings.
Corporate earnings trends
All-industry guidance calls for RP growth of 29.1% YoY in FY3/14 (based on TSE1 companies, ex financials, with a March fiscal year-end), which is 3.7ppt below the market consensus as at March 31. However, we do not view this as a negative surprise, as guidance tends to be conservative at the start of a new fiscal year. Earnings guidance is 3.3ppt higher than Japan Company Handbook forecasts as at March 31. This is the fourth time since FY00 that guidance has been higher and the 3.3ppt gap is the third largest, which is a positive surprise. Market consensus estimates have continued to increase after results announcements, which we think reflects the yen’s ongoing depreciation.
Next week’s focus: What is behind the volatility of Japanese equities? This week’s overview: Nikkei posts its 10th biggest drop ever on May 23
Quantitative analysis: Factor effect, sector gains and losses
Reference materials: Corporate earnings trends
Economic calendar: Data due out this month
JApanese Equities: TOPIX fell 6.9% on May 23
TOPIX fell sharply on May 23, dropping 6.9% compared to the previous day’s close. We think a direct catalyst was news that HSBC’s China’s manufacturing PMI hit a preliminary reading of 49.6 for May, dropping below the 50 mark for the first time in seven months, which fueled concerns that China’s economy continues to slow. We believe there are other issues that should also be kept in mind with regard to near-term investment in Japanese equities.
Japanese Equities: Widest 200-day moving average spread in 60 years
First, Japanese equities advanced at an extraordinarily rapid rate through mid-May. By May 20, TOPIX had pulled away from the 200-day moving average by 44.1%, which is the widest spread in about 60 years, since February 1953 (Figure 1). The rally reflects fading pessimism about Japan’s economy and earnings as a result of the BoJ’s aggressive monetary easing and the rapid correction in the strong yen, as well as a correction in stocks that have looked undervalued for some time. However, we think a rally with this momentum was susceptible to a downward correction.
Japanese Equities : Liquidity has played a key role in the recent rally
We believe liquidity has played a key role in driving up Tokyo’s stock market. Share prices have risen sharply year to date against a backdrop of yen depreciation and a decline in long-term interest rates. Amid aggressive global monetary easing, in April the BoJ announced what it called a “new dimension” of easing and in May the European Central Bank and the Reserve Bank of Australia cut interest rates again. Looser monetary policy and a weaker yen have generated expectations of a recovery in Japan’s economy and earnings, but the global economic recovery has been relatively weak since March (Figure 2). We think low interest rates have helped push up share prices as investors seek better returns, as is evident in the shift from bonds to equities.
Japanese Equities: Similarities with the “triple merit” stock market
In that sense, we see several similarities between the current rally and 1986, when the so-called “triple merits” (a strong yen, falling interest rates, and a decline in the oil price) were key market drivers. At the time, the dollar lost value against the yen as a result of aggressive monetary easing by the Fed and crude oil prices were falling, which triggered a decline in interest rates in Japan and a shift in investment to the stock market. Designated monetary trusts, known as “tokkin”, and other types of designated pecuniary trusts became increasingly popular and financial institutions and non-financial companies made substantial net purchases of Japanese stocks.
Japanese Equities: Lack of reliable valuations
Share prices were particularly volatile during this period. TOPIX gained 54.3% between its January 1986 low and August 20 high, then dropped 16.6% to an October low, before gaining 71.1% to reach another high in June 1987 (Figure 3). Buoyed by favorable financial conditions, Japanese stocks rallied strongly and previous valuation criteria no longer applied. Rising stock prices fuelled expectations of further increases, so when share prices fell this undermined investor confidence. We think this cycle helps explain why the market was so volatile. In 2013, we think one of the causes of the stock market’s volatility is the lack of reliable valuations. In fall 2012, some market observers believed Japanese stocks had lower P/E valuations than their US and European counterparts because of the structural issues behind the country’s shrinking and ageing population and its enormous government debt. Since the stock market’s rally, an increasingly widely-held view has emerged that Japanese stocks are still undervalued, even though the market is now trading above 17x FY13 EPS estimates.
Japanese Equities: Increase in index-linked foreign investment
We think another factor to consider is the increase in passive and index-linked foreign investment in Japanese equities. Japanese equity ETFs in the US have grown rapidly since 2012. As at May 22, 2013, the iShares MSCI Japan Index Fund held $12.6bn in assets under management and the WisdomTree Japan Hedged Equity Fund held assets of $10.8bn (Figure 4). We think it is relatively easy to move a large amount of money in a short period of time when investing in index-linked funds, which do not require detailed analysis of individual stocks. For this reason, we think the market tends to be more volatile when there is a much higher level of index-linked investment than active investment.
Japanese equities could continue to adjust in the short term