Stability masks headwinds for Japanese shares

The wild “risk on, risk off” moves in markets have increasingly been a source of investor frustration. But with share prices around the world seesawing violently since the middle of August thanks to the mood swings of the eurozone debt crisis and the global economic outlook, equity volatility in Japan has remained much tamer.

This has meant that on days when markets fall sharply, the experience in Japan has been less hair-raising than elsewhere. It is one indication that Japanese shares are cheaper than their international counterparts, says Pelham Smithers, managing director of his boutique research firm of the same name.

By a number of measures, Japanese stocks look attractive. The Topix index has a price-to-book ratio of 1.09 compared with the S&P 500, which stands at 2.01, and the FTSE Eurofirst 300, which is at 1.43, according to Bloomberg data.

And while the Topix’s dividend yield of 2.31 per cent is low compared with Europe’s 3.68 per cent, Japan looks more attractive than the US, where dividend yields are at a paltry 1.87 per cent, according to data from Macquarie.

But these factors may not be enough to spur Japanese shares into outperforming, analysts say, even if it does mean they are less volatile. The most traded Japanese stocks by international investors – who have dominated trading in the country – tend to be cyclicals, electronics and the manufacturers of capital goods as well as carmakers. These sectors are all subject to the highs and lows of the global cycle and investors at present are either divided or uncertain about future growth and the likelihood of a solution to the eurozone’s debt problems. In addition, investors are still deleveraging around the world, which reduces trading volumes.

The yen, which hit another post-war record of Y75.82 against the US dollar late last week, is another negative factor for the wider market and for exporters in particular. The currency’s strengthening has prompted finance minister Jun Azumi to step up the rhetoric – complaining it is hurting exports in general, especially cars, and threatening “decisive steps” – and analysts are therefore braced for more government intervention to weaken it.

“You might as well buy a Michelin with a weak euro rather than Bridgestone with a strong yen,” says Peter Eadon-Clarke, chief Japan strategist at Macquarie Securities. “The principal driver of net inflows is the swing in the global cycle. No one would want a global cyclical in Japan when they can go and buy some really boring telecoms stock in Europe with a 7 per cent yield.”

Investors are also considering the potential impact of the prospect of higher taxes as the Japanese government tries to put its fiscal house in order, says Mr Eadon-Clarke.

To deal with these challenges, many investors and analysts are calling for more action by the Bank of Japan to ease policy. Last year the BoJ started buying risk assets such as exchange-traded funds and real estate investment trusts to try to encourage more investor risk-taking activity. Some analysts argue this helped to put a floor under the stock market in early November following the central bank’s announcement.

However, Seiichiro Iwasawa, of Nomura, believes the Bank of Japan should ease policy further, buying up to Y2,000bn in ETFs compared with the existing target of Y1,400bn.

“Market participants, including me, feel that the BoJ does not believe in what it is doing,” Mr Iwasawa says. “If they really believe in what they are doing, they should boost it.”

Despite these measures from the BoJ, the Topix is trading even lower than last year’s bottom of 803.12, closing on Monday at 755.44. That is also lower than the two-day plunge of 16.3 per cent following the March 11 earthquake and tsunami.

And Japanese stocks may not have reached the floor yet. Mr Smithers notes one sign of the bottom of the Japanese market has historically been when the level of outstanding cash arbitrage positions on the Nikkei 225 index reaches approximately 500m shares – as happened in 1992, 1998, 2003 and 2009. At present it remains above 1bn shares, according to Bloomberg data, suggesting investor sentiment is still relatively bearish.

This implies “we may not have had the final sell-off for the Japanese market,” Mr Smithers says.

“It is the dog that hasn’t barked.”