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July 07, 2003

Whither Japan!
by David Chapman

Japan has broken out on the charts. Indeed it broke out about 7 weeks ago. So why are we so belated in telling everyone about it? Our prime reason is that at this stage we are uncertain as to whether this is the first wave of a much stronger move or merely just a rapid correction to a decline that started with tops in early 2002.

The Tokyo Nikkei Dow (TND) last made a significant top in April 2000 at around 20,800. This timing was in alignment with the top in the US markets. Since then the TND fell some 63% bottoming in May 2003 near 7600. The big top in the TND of course occurred back in January 1990 at 38,900 so 13 years later the bottom was down 80% from those heady days. Of course that 80% collapse (almost rivaling the collapse of the Dow Jones Industrials 1929-1932 that fell 89%) may not be over as the recent break out may just be the start of another bear market rally.

Over the years the TND enjoyed rallies of about 34% (1990-1991), 52% (1992-1994), 57% (1995-1996) and 62% (1998-2000). To put this in context the S&P 500 has since its top in 2000 enjoyed rallies of about 22% (2001), 24% (2001-2002) and 32% (2002-2003 to date). The TND's rallies have been overall far more impressive so despite it is up already an impressive 29% there could be a lot more to come. But that will occur only after a successful test of the break out lines and the key moving averages. The 1998-200 rally for example had a fast 20% gain followed by a 76% retracement. Recent indications plus numerous negative divergences in the indicators suggest that a top may be nigh and a pullback will occur. It is this pullback on Japan that should be monitored for a potentially interesting buy for at least a c wave of a corrective rally.

We do not believe that Japan's decade long plus nightmare is over. The first thing we note that while we certainly broke the downtrend line as seen on the weekly chart and there were numerous positive divergences in indicators we still see no sign that we are forming any kind of meaningful bottoming pattern. In fact all this may be, as we noted earlier, is a corrective wave to the 5-wave move down from the 2002 highs. We note that thus far since that 2000 high we fell nicely in a distinctive 5-wave decline followed by an abc rally into the 2002 high. Clearly new lows under 7600 would negate any potential for a further rally.

Japan's problems have been well documented. A bubble in the 1980's fueled by easy money policies and a banking system that fell all over itself to lend. This was followed by a collapse, numerous bankruptcies and a banking system that is long overdue for reform (as they dither and dally) and is essentially bankrupt itself. Despite years of low (almost zero%) interest rates, huge savings earning virtually nothing with an aging population and growing domestic budgetary deficits and numerous fiscal measures little has happened to drag Japan out of its malaise. Japan still suffers from a poor investment climate, uncertain job prospects, weak exports to the US in particular despite a continuance of a positive trade surplus, one of its few bright spots, and structural problems that includes mostly the bankrupt banking system.

Worse, all of the global problems with SARS, the Iraq war, the war on terrorism has ensured that Japanese tourism to other countries is down sharply hurting other economies particularly Canada and the United States. But Japan's biggest bugaboo has been deflation. Consumer prices have been falling for years. That in turn undermines corporate profits, slashes property values and stock portfolios, and increases debt burdens and delays spending. While Japan's economy muddles in and out of recession there is constant hand wringing of what to do and a lot of inaction in actually doing much of anything.

The recent decline of the US$ has also been most problematic for Japan. Japan does not want its currency, the Yen, to strengthen appreciably against the US$ as it would undermine their export economy particularly to the US. The result was that in the recent decline the Japanese were seen to be in the market trying to keep their currency down mostly by buying US securities. For example in some recent large US Treasury Bond issues Japan was seen as a major buyer. Oddly now that the US Treasury Bond market appears to have topped they have been seen as sellers to place the proceeds in their own stock market that broke out coinciding roughly with the top in the US Treasury Bond market.

One strong argument for Japan making a bottom has been presented by Ned Davis Research. They suggested in a recent note that Japanese stock yields are almost twice Japanese bond yields. This makes for the argument that an investor would prefer to hold stocks to bonds. As well on a relative valuation basis not only are Japanese stocks cheap in relation to Japanese bonds, Japanese stocks are also cheap relative to US stocks when accounting for bond yields in both countries. Even if this turns out to be merely a corrective move then Japanese stocks may still make a better investment on any significant pullback.

One thing we have often noted is a similarity between the current US market and the Tokyo Nikkei Dow after it made its highs in 1990. This is worth showing again because it is remarkable. First we want to show our chart of the Tokyo Nikkei Dow weekly up to July 7, 1993. Note what appears as a huge head & shoulder top on the Nikkei Dow. Lows were made roughly three years apart in November 1987 and again in October 1990. An important low was made in August 1992 followed by a sharp rally that took it back to the neckline of the huge head & shoulders pattern. The all-time highs were made in January 1990. The possible head & shoulders pattern has measuring implications for a long-term target down to around 3500-4000. To date the low has been to around 7600.

Our second chart is the S&P 500 weekly. Again we note significant lows roughly three years apart in October 1998 and again in September 2001. The all-time highs were made in March 2000. Following a break of the neckline of the head & shoulders pattern a significant low was made in October 2002. This was then followed by a rally back to and in this case above the possible neckline of the head & shoulders pattern. We have noted before that the measuring implications for this possible head & shoulders pattern is an eventual fall to roughly 330-350.

So what followed for Japan getting back to the neckline in July 1993? After a short pullback the Japanese market made a secondary top in September 1993 then a sharp pullback into November/December 1993 then a further rally into June 1994. After that Japan once again fell off the cliff to new lows in July 1995. So is there hope here for the S&P 500 and the North American markets following what could be a correction in the latter part of this year? Obviously the easy answer is if we continue to generally follow Japan, as we appear to have thus far then there is hope that we could continue this into 1994. This does fit the bullish scenario of some pundits and as well fits with what was probably a four-year cycle low made with the multiple lows in July and October 2002 followed by another test in March 2003.

But with the muddle through economy, the current overvaluations in the market, sluggish profit growth, the twin deficits both budget and trade deficit and the huge debt load for both corporates and consumers they currently seem to be not bothering the market. Eventually it will of course. But if we follow the Japanese scenario we could last into 1994 before we really go off the deep end again. As we move further into the second half of the year the odds certainly favour at least a sharp pullback in the market if not an outright panic. After all if California can go bust, as it appears might be the case, could things get worse especially if there was an outside shock to the system?

But wither Japan? The charts seem to suggest that at least a significant correction is underway. Investors should only consider it on the inevitable correction to the current up move. What remains to be seen is will this current up move have even stronger legs after a pullback. The ongoing Japanese nightmare appears to suggest not yet anyway. But valuations suggest it just might. Keep a close eye.

DavidChapman.com
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
69 Yonge Street, Suite 600,
Toronto, Ontario, M5E 1K3
(416) 604-0533
(416) 604-0557 (fax)
1-888-298-7405 (toll free)

David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.

The information in this report is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does Union Securities Ltd. assume any responsibility or liability. Estimates and projections contained herein are Union's own or obtained from our consultants. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any securities and is intended for distribution only in those jurisdictions where Union Securities Ltd. is registered as an advisor or a dealer in securities. This research material is approved by Union Securities (International) Ltd. which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the U.K. The investments or investment services, which are the subject of this research material are not available for private customers as defined by the Financial Services Authority. Union Securities Ltd. is a controlling shareholder of Union Securities (International) Ltd. and the latter acts as an introducing broker to the former. This report is not intended for, nor should it be distributed to, any persons residing in the USA. The inventories of Union Securities Ltd., Union Securities (International) Ltd. their affiliated companies and the holdings of their respective directors and officers and companies with which they are associated have, or may have, a position or holding in, or may affect transactions in the investments concerned, or related investments. Union Securities Ltd. is a member of the Canadian Investment Protection Fund and the Investment Dealers Association of Canada. Union Securities (International) Ltd. is authorized and regulated by the Financial Services Authority of the U.K.

Copyright © 2002-2008 David Chapman

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