The Reflation and Releveraging of Japan
July 27, 2008
Let us begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 801.31 points as of Friday at the close.
7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 492.31 points as of Friday at the close.
Make no mistake: We are not particularly happy with the results of our DJIA Timing System over the last several months, even though our one-year performance as of June 30th was 17% above the performance of the Dow Jones Industrial Average. Obviously, no one can time the market or sub-sectors of the market perfectly - but given the recent correction (and diminishing Chinese and Indian demand growth) in energy prices, the weekend passage of the latest housing bill, the extremely oversold conditions, the unprecedented amount of capital sitting on the sidelines, and overall decent valuations in the global stock market, my sense is that we will see gains in our two latest buy signals sometime over the next few weeks. As I mentioned in our past couple of weekend commentaries, I anticipate at least a two-month rally going forward - although, I will, as always, continue to monitor the markets closely and inform our readers ASAP should we change our overall bullish stance. To paraphrase Keynes, we would not hesitate to change our stance should new market information come into conflict with our views. We're paid to adapt as well as predict.
Before we go on with our commentary about Japan, I would like to briefly discuss my thoughts on the GSEs - that is, Fannie Mae and Freddie Mac. First of all, the latest Financial Times column by Larry Summers on the GSEs is a must-read - as Dr. Summers' opinions are widely read by policy makers and institutional investors worldwide. Now, here are the facts as we know it on Sunday evening, July 27th:
We know that the US Treasury and most other policymakers see nationalization (i.e. with Treasury directly injecting capital into the GSEs) as an option - but for now, it is to be used only as a last-resort option. In the meantime, Paulson and others have continued to urge the GSEs to raise more capital - not only to make sure the GSEs will remain solvent (on a fair value basis), but to also allow the GSEs to originate or buy more mortgages to rejuvenate the U.S. housing/mortgage market. The explicit guarantee by Congress and the latest short-selling rules are meant to prop up the prices of the GSEs' preferred and common stock - which would thus help them more easily raise capital going forward.
In retrospect, there were two significant policy mistakes made with regards to the housing market over the past several months. First, Richard Syron, the CEO of Freddie Mac, had announced plans in May to raise $5.5 billion in capital (on top of the $13.5 billion raised last year) to prop up its balance sheet, but that he would not do the offering until August - as he was waiting for its lawyers to register with the SEC (this shows why you should never ask a lawyer for strategic advice). Since May, the cost of capital for both Freddie Mac and Fannie Mae have hit near debilitating levels. Second, Congress went back to its "merry ways" of dragging its feet and celebrated the July 4th long weekend without passing the $300 billion housing bill. Since the short-term bottom in stock prices in mid March, the global financial markets have been anticipating the bill to pass relatively quickly. To say that this was a disappointment is a major understatement. If Freddie Mac had raised the $5.5 billion two months ago, and if Congress has passed the $300 billion housing bill before the July 4th weekend, there is a good chance the US government may not be talking about a bailout today, although that is not to say it wouldn't happen down the road.
Assuming Freddie Mac raises $10 billion in capital over the next several weeks, it is a near certainty that the GSEs would need to raise another $10 to $30 billion over the next 18 months in order to remain "solvent" on a fair value basis, given the current trend in foreclosure and delinquency rates. The $64 billion question is: Will the financial markets "cooperate" and allow the GSEs to raise such a high amount of capital (at 60% to 180% of the GSEs' total market cap today)?
More importantly, what fundamental analysis cannot cover is the fact that the GSEs also have a social function as stated in their charters. That is - even if the GSEs were able to raise enough capital to satisfy the OFHEO's (or more importantly, the market's) capital requirements - they would still need to drastically reduce lending and the purchase of mortgage securities in order to conserve capital. Assuming the idea of "cover bonds" (which Paulson is now pitching) does not become a popular vehicle of mortgage financing among private financial institutions, the decline in housing prices will reinforce itself - leading to more losses and housing price declines. Obviously, this is politically unacceptable given the "social mandate" of the GSEs. The $64 billion question then becomes: At what point will Treasury come in and effectively nationalize the GSEs by injecting a significant amount of equity capital (resulting in a severe dilution of the common), and flood the mortgage market with cheap loans? Will the Obama Administration be more willing to nationalize the GSEs and "kill off" the common and preferred shares (my guess is "yes")?
If you are holding the common or preferred shares of the GSEs today, then these are all legitimate questions you should be asking. It is also a highly complex situation - as it not only involves financial, psychological, and economic variables, but political and social variables as well. However, what we know is this: The sooner the Administration recognizes that the GSEs are acting as a burden on the housing market (as opposed to its social mandate of liquefying the housing market during a general housing recession), the better off it is for the US stock market and the economy. Barring a significant recapitalization (>$50 billion), we know the GSEs cannot be both solvent and to have the ability to reliquify the mortgage market. Such a significant recapitalization will inevitably require a severe dilution of current common and preferred shareholders. Just like the Bear Stearns bailout, what is bad for the GSEs' common and preferred shareholders will be good for the U.S. stock market (and financial stocks) in general (at least in the short to intermediate term). At this point, however, I don't see nationalization or a significant recapitalization on the horizon.
Let us know discuss Japan. As long-time readers may know, we have had a bias towards the Japanese stock market (vs. both a global equity and a global bond/equity portfolio) since late January of this year, as we discussed in our January 31, 2008 and February 3, 2008 commentaries, and our discussion forum. Our arguments for having an overweight in Japan is still valid, as the Japanese stock market (as measured by the Nikkei) is still at the same level as it was during late January. Moreover, valuations continue to remain very decent, as Japanese banks have for the most part dodged the "subprime bullet" and as Japanese earnings have held up well despite a global economic slowdown.
More importantly, the Japanese stock market is the only major equity market in the world where a rise in consumer price inflation has generally preceded a rise in equity prices over the last ten years. Given the latest rise in global inflationary pressures, Japan is now the "equity market of choice" for investors. This is especially important since most institutional investors are still very much underweight Japan in their global equity basket. In addition, Japan is making incremental but sure steps to improving its corporate governance structure, as demonstrated by 1) The refusal of the Japan's Pension Fund Association to vote for the reelection of directors at firms that earn a ROE of less than 8% for three consecutive years (the average ROE of Japanese firms is around 10%, or just half of the ROE of US-based firms), 2) Some firms, such as Shiseido, the cosmetics company, and Nissen, a mail order company have opted to drop their takeover defenses, 3) Over the past 10 to 15 years, the Japanese commercial code has actually been overhauled to make corporate restructuring and thus M&A deals easier. Given that the average ROE of Japanese companies is only half that of US companies, just a slight improvement in corporate governance could propel Japanese earnings significantly higher going forward.
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