Call it the “Abe put.” Since his overwhelming election victory last month, Prime Minister Shinzo Abe has wasted little time in launching a promised multitrillion-yen infrastructure spending plan, issuing a whack of new debt and ratcheting up pressure on the Bank of Japan to crank up the printing presses to drive down the value of the yen. This Krugmanesque drive to revive Japan’s moribund economy by turning the stimulus taps wide open and driving up the country’s already mountainous public debt has had a positive effect on at least one asset class – equities.
The Japanese market has risen 5 per cent since the start of the year and almost 10 per cent since the election, despite weak economic data. During that period, the yen has fallen about 7 per cent against the U.S. dollar.
The market is more sensitive to exchange rate moves than the economy as a whole. A falling currency attracts more foreign players to Japanese shares, particularly those of export-driven manufacturers, which dominate the market and whose profits are directly affected by the yen’s direction. When the yen spiked last Wednesday, equities briefly plunged. But this was only a blip in what promises to be a year of stronger corporate profits and rising stock prices, as Mr. Abe’s government does everything in its power to tamp down the yen and pull Japan out of its deflationary spiral.
The bold fiscal and monetary measures may do nothing for the broader economy, particularly if the government fails to tackle such critical but politically thorny issues as financial and tax reforms and structural impediments to a more competitive domestic landscape. But monetary easing tends to drive capital into financial assets. And most investors would be satisfied with shorter-term gains in a stock market that has been a chronic underachiever for years.
In Japan – or anywhere else – just because stocks seem bargain-priced, it doesn’t make them screaming buys. As more than a few rueful investors can attest, inexpensive stocks can stay that way for an awfully long time.
“Stocks being cheap doesn’t drive them up,” agrees economist Andrew Smithers, a long-time Japan watcher and an expert on stock market valuations. “But when you’ve got rising profits and stocks are cheap, you’ve got quite a good combination.”
The Japanese market “is not only much better value than that of the U.S., it is probably selling below fair value,” Mr. Smithers said in a note to clients last week. His London-based firm, Smithers & Co., advises investors on international asset allocation.
Using traditional valuation methods that he has long championed, Mr. Smithers calculates that U.S. stocks are anywhere from 40 to 50 per cent overvalued. “We know that the market in America is heavily overpriced,” he says, curtly dismissing market types who argue that U.S. equities are still trading at steep discounts to historical averages. “It’s no good asking for an unbiased judgment from somebody whose livelihood depends on being biased.”
U.S. stocks are cheaper than in the notorious runup to the 1929 crash or the crazy days leading up to the bursting of the tech-stock bubble in 2000. But they have climbed to about the same levels as in peaks reached in 1906, 1937 and 1968, all of which were followed by nasty and extended bear markets, Mr. Smithers says. “But don’t expect that to tell you much about what’s going to happen in the short run. If markets went down when they were expensive and went up when they were cheap, they would never get mispriced. And we know that they do.”
Japanese non-financial companies “will almost certainly give much better returns” over time, he wrote in his report. “Indeed, it would need some major catastrophe to hit Japan, but avoid the U.S., for this not to be the case.” Still, Mr. Smithers acknowledges that for most investors or money managers, “the probability of higher long-term returns is seldom a major consideration.”
When asked what triggers a change in sentiment, the blunt-spoken economist offers a single word: “profits.” And that’s where Mr. Abe and his bag of Keynesian tricks comes in.
Mr. Smithers estimates that Japanese corporate profits will rise in the fiscal year starting April 1 by close to 40 per cent, thanks to the weakening yen and the hefty stimulus boost from the government. Fiscal expansion in Japan will equal about 2 per cent of gross domestic product. By contrast, fiscal contraction in the U.S. will amount to 1 to 1.5 per cent of GDP.
For Japanese equities, the issue is whether the market can look beyond the dismal corporate results for this fiscal year “to the very strong profits we’re likely to get in the year to March, 2014,” he says. “If profits are going up sharply, it’s a little dangerous to be out of a cheap market, particularly as profits are not likely to be very good in America in 2013.”
Earnings per share on the broad Tokyo Stock Price Index (Topix) will rise 56 per cent in the next year, based on estimates gathered by Bloomberg, compared with a much more modest 13 per cent gain for the S&P 500 and 27 per cent for the Shanghai composite index.
The sensible way to play all this is through an index fund, Mr. Smithers says. “I’m not a share picker.”