Japan - A Final Goodbye to Deflation

By: Henry To | Fri, Feb 16, 2007
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Dear Subscribers,

While it is definitely nice to be back (thanks for writing a guest commentary for us last weekend, Bill) to be writing a commentary for all of you, I have to say that taking a whole weekend off last week and staying at the Hotel Del Coronado in San Diego wasn't such a bad experience either. The "Del," as they call it, has a rich history going back to its founding in 1888 - and has been visited by ten U.S. Presidents starting with Benjamin Harrison in 1891. For those who are thinking of visiting San Diego, I urge you to at least pay the "Del" a visit if you get a chance.

Before we continue with the rest of our commentary, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,195.83 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,075.83 points

Given that the S&P 500 has been up eight months in a row for the month ending January, and given that February has tend to be a seasonally weak month for the stock market, there is a good chance that the market should continue to experience some weakness over the next few weeks. Adding more uncertainty is the potential reaction of the Japanese Yen to the latest G-7 Meeting that ended on Saturday. Barclays has estimated that the Yen carry trade is now at its biggest since 1998 - and subsequently, all it takes is a little volatility in the Yen for traders to start covering their short positions (carry trades only make sense in a low volatility environment). There is currently no way to tell if certain hedge funds have overextended themselves on the short side of the Yen - but if there is - then any potential fallout resulting from this could potentially spill over to the global equity markets as well. Readers please stay tuned.

That being said, as of Sunday afternoon on February 11, 2007, we are still fully (100%) long in our DJIA Timing System and is still long-term bullish on the U.S. domestic, "brand name" large caps - names such as Wal-Mart (which is now making a serious effort in the Chinese market by acquiring Taiwanese-owned Trust-Mart and naming a more aggressive new head of operations in China), Home Depot (which is now also expanding in China), Microsoft (I expect Vista to rake in the cash over the next couple of years), IBM, eBay, Intel (Intel is now close to two generations ahead of AMD), GE, and American Express. We are also bullish on Yahoo, Amazon, and most other retailers as this author believes that "the death of the U.S. consumer" has been way overblown. We also believe that the combination of Microsoft Vista, Office, commercialization of the solid state hard drive, and commercialization of solar energy will be a boon to semiconductor companies, such as SanDisk, Samsung, and Applied Materials. Moreover - judging by what we saw at the Consumer Electronics Show in Las Vegas a couple of weeks ago, there is a good chance we are now seeing a revival of Sony as a great global corporation (barring a global economic recession, the rest of this and the next decade will be known as the age of the emerging market consumer). We also continued to be very bullish on good-quality and growth stocks in general.

I am also bullish on Taiwanese equities - specifically the iShares Taiwan Index (EWT) as mentioned in our mid-week commentary. In short, I believe both the Taiwanese stock market and the Taiwanese dollar are extremely undervalued - and that a catalyst for higher prices is just around the corner. Among the reasons are:

While the current adoption rate of MS Vista and Office 2007 is mediocre at best, it is interesting to note that the reception of Windows 3.0 when it was released in 1990 was also lukewarm at first. As a matter of fact, a one-year anniversary article published on May 8, 1991 states: "Windows has become a checklist item for hundreds of large corporations, but it remains to be seen how fast top management will agree to massive hardware and software upgrades (in a recession, no less) to achieve speculative gains in white-collar productivity. We think it's more likely that Windows first will have to prove itself in hundreds of pilot projects before we see large-scale adoption of mass-market applications. In the short run, the fastest penetration of Windows products is likely to occur in specialized niches, among individual users who will insist on superior functionality, not just pretty screens." As we all know, the rest is history. As of today, my partner/webmaster, Rex, is already using Vista and loving it. I will upgrade later this year once the Service Pack 1 is released (crossing my fingers) and once solid state hard drives have been integrated into the various Dell and HP laptops. As an aside, the most recent dip of MST below $29 is a good buying opportunity, IMHO.

Moreover, the Taiwanese iShares (EWT) are also undervalued relative to the technology/hardware/software sector of the U.S. stock market. The following table shows a comparison (using forward P/E and other mainstream valuation ratios) between the iShares Taiwan index relative to the SMH, the Morningstar Software Sector Index, and the Morningstar Information Economy Index as of December 31, 2006.

Comparison between the iShares Taiwan index relative to the SMH, the Morningstar Software Sector Index, and the Morningstar Information Economy Index as of December 31, 2006.

As shown on the above table, both the forward P/E and the forward dividend yield of the iShares Taiwan Index are substantially lower than the corresponding ratios of the U.S. technology and semiconductor sector. Coupled with the undervalued Taiwanese dollar and the fact that earnings growth will also be in the double digits in Taiwan, my guess is that the Taiwanese stock market will surprise on the upside during 2007.

But Henry, the Taiwan iShares are only 50% weighted in technology and semiconductor equipment - how about the rest of the sectors that make up the index?

Good question. Aside from the technology sector, another sector that has a significant weighting in the Taiwanese iShares is the financial sector (commercial banks and insurance companies) - with a weighting of slightly over 15% (10% in commercial banks and 5% in insurance companies). One major factor that has been inhibiting the growth of the Taiwanese financial sector has been the Taiwanese government's prohibition of the Taiwanese financial sector to invest in Chinese financial companies or do business in China. Given the recent successes of banks such as HSBC and Bank of East Asia, however, Taiwanese financial companies have been lobbying (and succeeding) for a rule change. This legislation change is scheduled to come in the second half of 2007.

Following is a chart courtesy of Goldman Sachs showing the discount that the Taiwanese financial sector is trading at relative to both its Hong Kong and Chinese peers. As we approach the passing of this legislation (which is by no means guaranteed, of course), Taiwanese financial shares should revalue and "catch up" with the valuations of both its Hong Kong and Chinese peers.

Taiwan financial sector is trading at a widening discount to its regional peers

More importantly, Taiwanese banks and insurance companies also have two distinct advantages in doing business in China vs. financial companies from other countries (including those from Hong Kong):

1) Many Taiwanese companies and individuals who have emigrated to China to do business already have relationships with the incoming Taiwanese banks. In the Chinese culture, relationships (known as "guanxi") is everything - meaning that the Taiwanese banks and insurance companies have already gained a strong foothold into China even before they have physically built a single branch on the Mainland.

2) Management that is predominantly Mandarin-speaking. Again, this will allow them to gain a strong foothold without significant investments - at least initially anyway. Once the Taiwanese banks are able to establish a strong foothold in China, the rest will come relatively easy (such as hiring foreign currency and risk management personnel - areas that they are currently lacking in talent).

Let us now get to the gist of our commentary and discuss Japan. First, I want to make one thing clear: All I am suggesting in this commentary is merely that Japan is exiting out of his deflationary spiral - a spiral which Japan has been struggling to exit ever since its stock and real estate market burst in 1990. While I believe the Japanese stock market (and the Japanese economy) will perform decently this year, I still believe the US stock market is the place to be (if one is solely focusing on the "developed markets") - either vs. Japan or Western Europe. In order to make this easy, I will summarize our thesis and reasoning in "point format." They are - in no particular order:

1) After exporting deflation for most of 2005 and all of 2006, China is once again exporting inflation - based on the latest Hong Kong re-export prices data. This not only has profound implications for Japan and the rest of Asia, but for most of the world engaged in foreign trade as well. In essence, this will take the pressure off most of Asia to intervene in the currency markets to curb the rise of their respective currencies - as well as to allow them to raise prices. For an exporting country like Japan that has been mired in a deflationary spiral, this is literally a Godsend.

2) Not only is Japan in its longest period of economic expansion since the bubble burst in 1990, but fourth quarter real GDP growth (which will be released this Thursday) is also expected to be respectable at 3.9%. For 2007, Japan's GDP growth is expected to be slightly over 2%. Corporate margins are also high - despite continued double-digit increases in capital spending. The only "fly in the ointment" has been the disappointment growth (or lack thereof) of Japanese consumer spending. The culprit? Lack of real income growth despite high corporate profit margins. I expect this to change going forward as the Japanese labor market continues to remain tight. In fact, the Japanese unemployment rate has been vacillating between 4.0% and 4.2% during 2006, as shown by the following chart courtesy of the Japanese Statistics Bureau. Should the Japanese unemployment rate decline below 4.0% in the coming months (right now, there are ample jobs available for anyone that wants them in Japan), then real income growth is pretty much a given:

Japanese unemployment rate 2003 to 2006

3) For the first time in 16 years, land prices in Tokyo, Osaka, and Nagoya (the three largest urban areas in Japan) rose in 2006. Moreover, the average grade-A office market vacancy rate in Tokyo declined from 1.8% at the beginning of 2006 to 0.3% by the end of the year. As recently as 2003, the average grade-A office market vacancy rate in Tokyo was 12.3%. Rents in this market also rose 48% on a year-over-year basis in 2006, on top of a 44% increase in 2005. Following is chart courtesy of Prudential Real Estate Investors showing grade-A office vacancies in the major real estate markets in Asia:

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Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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