Well-Trained Japanese Investors are Shorting the Nikkei

We have been a bit surprised to learn that short bets on Japanese stocks have recently surged significantly. Evidently, Japanese investors are well-trained by now: they don’t expect rallies in Japan’s stock market to hold or continue. However, Japanese stocks actually remain fundamentally quite cheap, in spite of the notable surge from their 2012 interim lows.

According to Bloomberg:

“As bets pile up against Japanese stocks, investors with $293 billion in client assets see the pessimism as a signal to buy. History is on their side. Short-selling on Tokyo’s bourse jumped to the highest on record this month, as the Topix index tumbled 7.7 percent from a six-year high in September. Shares have rallied an average 9.7 percent over the three months following surges in bearish bets since 2009, according to data compiled by Bloomberg.

For Sydney-based AMP Capital Investors Ltd., that’s one reason for optimism. The outlook for company profits is another. Government-backed steps to put a floor under Japanese equities may prove dangerous for short-sellers: the central bank says it’s ready to add stimulus if the economy falters, while on Oct. 20, a Nikkei newspaper report the country’s $1.2 trillion pension fund would buy local shares roused the Topix from a three-week rout.

“Fear is hitting extreme levels and it’s time to get into the market,” Nader Naeimi, who helps manage about $125 billion as head of dynamic asset allocation at AMP, said by phone on Oct. 14. “When these sentiment indicators flash excessive pessimism, it usually suggests we’ve reached the lows.”

Bearish bets accounted for 36.6 percent of all transactions on the Tokyo Stock Exchange by value on Oct. 14, according to bourse data compiled by Bloomberg. That’s the highest since the exchange started publishing the figures in 2008. The ratio was 33.4 percent on Oct. 24.”

Generally speaking a surge in short bets is a contrarian bullish sign. However, as the article excerpt above indicates, the amount of available historical data is fairly small. It would be a lot more informative if we were able to see what happened in the many ups and downs the Nikkei has experienced since its secular bear market started in late 1989 (yes, it’s been a while since the Nikkei put in its manic bubble peak).

The Nikkei has exhibited a very strong negative correlation with the yen in the past two years, so a lot will presumably depend on whether the yen actually remains weak. Note however that the Nikkei has not alwayscorrelated negatively with the yen. In fact, recently a weaker yen has failed to provide much of an additional boost, so the correlation is weakening a bit of late.

We would still expect the yen to strengthen if global stock markets were to come under pressure, as this usually leads to the liquidation of carry trades as well as to repatriation of investments by Japanese institutions. However, given that the Nikkei has performed very badly compared to other developed markets since its 1989 peak, it is certainly conceivable that it will do the opposite for a while (this is to say, in the medium to longer term; short term, the Nikkei tends to simply be more volatile than e.g. the US market, but usually moves in the same general direction).

The Nikkei and the yen, weekly. Between the two charts you can see the 60-week correlation indicator. As can be seen, a positive Nikkei-yen correlation has been a rather rare guest in recent years – click to enlarge.

The Valuation Question

Valuations may actually hold the clue to the Nikkei’s future long term relative performance. While we would certainly expect the market to decline if Western stock markets were to fall, it may well decline less during downturns and rally more during upturns in coming years. As noted in the same Bloomberg article on this point:

“For Jefferies Group LLC, valuations suggest a rebound this time too. Some 889 of the Topix’s 1,811 companies now trade below the value of their net assets, according to data compiled by Bloomberg. This should be a warning to hedge funds taking overly bearish positions, according to Sean Darby, Hong Kong-based chief global equity strategist at Jefferies.

The Topix traded at 13.1 times estimated earnings on Oct. 17, the lowest level since May, according to data compiled by Bloomberg. That compared with 15.7 on the S&P 500 that day, the data show.”

We don’t give a lot of credence to “forward” P/E ratios based on analyst consensus estimates (in fact, we think relying on them is mainly a very good way of losing one’s shirt at important turning points) and we are not particularly convinced that the current “forward” P/E of 13.1 is so low as to be very enticing. After all, exporters are currently enjoying what is a strictly temporary profit boost at the expense of the entire rest of Japan’s economy.

However, when half of the shares on the exchange trade below book, there are surely good values to be found. With regard to profitability and more shareholder-friendly policies, Japanese companies still have a lot of catching up to do, but rumors that they are at least considering some improvements with respect to the latter point continue to persist. We will see about that (in this case, only seeing is believing).

Much will also depend on whether Mr. Abe’s government actually finally delivers on its long-promised economic reforms. So far “Abenomics” consists mainly of monetary pumping and the associated currency debasement, as well as a continuation of massive deficit spending. This kind of tinkering will mainly achieve the impoverishment of Japan’s citizens. For Japanese companies to be revalued by the market, there has to be tangible economic reform that fundamentally alters their prospects.

In recent months Japanese shares have actually largely gone sideways relative to the S&P 500, but have been able to hold on to the bulk of the relative strength they have gained since the 2012 low. Not that this means much, considering the long term performance of this market and the devastating decline in the yen. Foreign investors needed to hedge the yen to actually enjoy the full extent of the rally since 2012 (note though that yen-hedged vehicles are always exposed to the risk of a breakdown in the negative correlation). The relative strength comparison is close to a “make or break” point in the meantime, after having deteriorated noticeably this year:

Nikkei-SPX ratio. After strongly underperforming against the SPX until late 2012, the Nikkei’s relative performance has seen a strong boost, but it since early 2013 it has declined again – the yen however has continued to fall – click to enlarge.

Futures Positioning

Finally, below you can see how US futures traders have reacted to the recent correction. The chart shows the commercial hedger net position, which is the obverse of the combined big and small speculator position. With hedgers recently net long 3084 contracts, speculators have gone short Nikkei futures again for the first time since March 2013.

Note that they were net short for most of the Nikkei’s strong surge, and then went long just as it started going nowhere once again. Their recent adoption of a short position may therefore actually be a good sign for the Nikkei, but the long term record on this data point is a bit ambiguous. Most of the time since 1995, speculators were net long Nikkei futures (and thus quite often wrong), but they correctly anticipated the sharp decline of 2008-2009.

The hedger position in US-traded Nikkei futures. Speculators are now slightly net short again – click to enlarge.

Conclusion:

We don’t believe the Nikkei will decouple from Western stock markets in the short term. With speculators still heavily short the Japanese yen, some caution is probably advisable at the moment, especially as Japan’s money supply growth has recently slowed to a mere 3% year-on-year (the BoJ’s QE is not directly translating into money supply growth, in contrast to QE by the Fed. This is due to technical factors and the respectivemodus operandi of these central banks).

However, it seems not entirely inconceivable to us that the Nikkei could enter a period of relative strength in the longer term, mainly based on valuations and plans to adopt more shareholder-friendly policies. Note also that in spite of Japan’s negative demographic outlook overall, the so-called “middle-young ratio” suggests that stocks could get a bit of a boost from demographic developments in coming years.

Charts by: StockCharts, Sentimentrader