The Bloom is off the Boom, and the Yen also Rises

Our analyst sees the market dipping as currencies play power games

JAPAN'S THIRD QUARTER GDP came in at an annualized 2.2 percent. While that's better than the 1.5 percent foreseen by some consensus surveys, it was still noticeably slower than the surprising 3.5 percent of the previous quarter. Growth is still driven by capital expenditures and exports, with capital expenditures slowing from an annualized 4.7 percent in the second quarter to a more mundane 2.8 percent.

Moreover, consumer spending, which accounts for over half of the GDP, was flat with the previous quarter. In addition, while Japan's November elections were not a surprise, there was a slap on the wrist from voters in the form of a better-than-expected showing by the merged and re-energized Democratic Party, which had the Liberal Democratic Party circling the wagons and merging with a smaller member of its ruling coalition.

While we view this as a positive long-term development, the mixed signals from the elections were enough for stock market participants to pause and reflect. The relatively strong Democratic Party showing in the polls has investors considering the possibility of a policy shift toward a "hard landing" scenario, as the Democratic policy platform is less friendly toward banks and their deadbeat borrowers.

In reality, the bloom is already off the boom in Japan's surprising stock market rally to date, and for reasons including but not limited to the recent elections. First of all, there is evidence that the early, more aggressive hands among foreign investors are taking profits, and this is nowhere more apparent than in the sell-off of the banks.

We knew some time ago that the first sign of a correction in the Tokyo market would come from the financials. The Topix banking sector has sold off some 26 percent from a high of 255.68 and is now showing a bearish head-and-shoulders pattern after having corrected down to its 26-week moving average at around 190. We believe it is unlikely to breach 240 anytime soon, as anyone who wanted to own the financials already owns them and in very large quantities.

Individual investors have been handed their first major setback in the rally. Softbank, the darling of Japan earlier this year, has collapsed, crashing from JPY7,370 to JPY4,310, a fall of 42 percent. It announced a JPY77.3 billion deficit for the interim to September, the largest deficit the company has ever recorded.

Given the losses, individual investors have been dumping stocks to cover margin calls. Another sign that the bloom is off: The Topix Core 30 index of large-cap, internationally well-known blue chips has lost 13 percent from September highs and is also showing a bearish head-and-shoulders chart pattern. Now that the Japanese market has lost the leadership of the banks, the question is, what sector can take their place?

There has been some recent evidence of renewed interest in the long-dormant telecommunications sector, instigated by a positive surprise by NTT, with its latest quarterly results. NTT, the bellwether of the group and of the Japanese stock market as a whole, rose sharply during the 1999/2000 bubble, but has been bumping along the bottom since late 2001 and recently sold off again some 20 percent from October highs. NTT Docomo exploded fourfold during the bubble but did not confirm downside support until early 2003. It is now in the process of reconfirming downside.

But we wonder if the sector is ready yet for a sustainable rally. Pretax profit for NTT for the full year to March 2004 is now expected to rise a measly 0.5 percent from the previous year to JPY1.41 trillion. NTT Docomo reported a profit decline for the first half of fiscal 2003, the first decline since its listing in October 1998.

There are concerns about the limits to Docomo's business model. Revenue-related expenses such as incentives and paying for handsets amounted to JPY913 billion, an increase of 23 percent from the same term the previous year. The expenses equaled 36 percent of sales, a jump of 5 percentage points. This increase shows that even if costs are incurred to enroll and keep subscribers, Docomo's ability to expand sales is weakening.

Remember the Industrial Revitalization Corporation of Japan (IRCJ)? When it was just getting started in early May 2003, there was interest in companies that could be chosen by the corporation for corporate revitalization. But we were skeptical even before the corporation was established, and our skepticism has so far proven correct: The IRCJ is still muddling about with relatively minor local corporate revitalizations. Given the organization's unimpressive track record to date, we believe that any company sold on the possibility of a revitalization by the IRCJ will be shorted, as we first suggested way back in early September.

79 yen per dollar, BOJ or no BOJ
Preparations for American presidential elections later this year already have the US acting protectionist. But the US's major trading partners are not sitting still for its recent trade sanctions. Japan, the EU and China are all threatening to raise tariffs in retaliation.

What makes investors nervous about these trade friction games is that everyone knows the US's balance of payments is a problem and the dollar is overvalued. This is why the US plays a "strong dollar policy" charade while quietly allowing the currency to depreciate. A Federal Reserve study suggests that the dollar could drop at least another 20 percent. If the dollar depreciates too quickly, it could precipitate a sell-off in stock markets (like Black Monday in 1987, which was instigated by then Treasury secretary James Baker's attempts to push the dollar lower).

US economists have already noted that overseas portfolio inflows into dollar assets have recently fallen far short of the $46 billion required to finance the US current account deficit. With rising US budget deficits and little hope of an offsetting surge in private savings, this would only reinforce expectations of further US dollar weakness.

By the same token, the Japanese stock market and the Japanese government are very sensitive to further sharp appreciations in the yen. A significantly stronger yen hurts the stock market in two ways: It will work to blunt the recovery in corporate profits, and it will exacerbate the deeply entrenched deflation the Japanese government has been trying so hard to eradicate.

This past year, the Japanese government has intervened in the currency markets to support the yen in massive amounts, spending a record JPY16.2 trillion by the end of October to prevent the dollar from breaching the JPY100 mark. It apparently spent another JPY1 trillion in late November to keep the yen above 107 to the dollar. But since the real driver behind the yen's appreciation is basically a US dollar problem, the best the Bank of Japan (BOJ) and the Japanese government can do is to merely smooth the yen's appreciation against the dollar.

Here at J@pan Inc we see no reason to change our view that the yen will continue to challenge the 100-yen-to-the-dollar milestone and could eventually attempt to renew its prior JPY79 high against the dollar. A yen at this level could reduce Japan's GDP growth by some 1 percent. The consensus of recent estimates by domestic think tanks is that Japan's real GDP growth will slow from 2.6 percent this year to 2 percent in fiscal 2004. Nominal GDP, which better reflects what corporate sales look like, will be zero this year and minus 0.3 percent in fiscal 04.

Since the correction began in recent months, only the healthcare and telecom services sectors have managed to record gains. Japan's IT sector, as expected, has lagged behind its global peers, but the global IT sector as a whole has seen profit-taking.

However, it is Japan's banks that have taken the brunt of the selling. Technically speaking, the Japanese market indexes continue to deteriorate. The next development in the Topix could be a "dead cross" between the 13- and 26-week moving averages, which we expect to see by the time you read this. While investors are still ostensibly bullish, we believe that the Nikkei is more likely to see 9,000 by the end of the calendar year than the 12,000-13,000 suggested by many not long ago.

Last July, we put together a list called the "Dogs of the Nikkei." The members have made a pretty good accounting for themselves so far. The group has outperformed the Topix benchmark by 320 percent -- not bad for a bunch of "dogs." @