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March 01, 2007

Love Triangle?

Love Triangle?...Nope, we promise we'll leave any comments regarding US astronauts out of this entirely. It's been a while since we've brought up the subject of Japan. From a long cycle perspective we're bullish. Quite simply, if one believes the Asian economic sphere has a very bright future in terms of economic growth possibilities, as we do, it's very hard not to be optimistic about Japan. Will there be bumps along the way? Absolutely. In fact, global equity market action in the last few days of February should remind everyone of that. A very serious global economic recession could easily interrupt continued upward movement of the Nikkei at any time, but it seems a pretty good bet right now that the long term and very punishing bear market in the Nikkei started in 1990 saw its final lows a number of years back. But, as always, true bull markets never move in a straight line. And so we saw the Nikkei show us one of the worst 2006 developed economy equity market returns, after having turned in a very decent 2005. For now, especially given heightened global equity market volatility as of late, near term action is anyone's guess. In short, what lies ahead for the Japanese equity market and what should we be focused upon in terms of supporting the rationale for the Nikkei continuing to be in the midst of a long cycle recovery? We have a few thoughts.

First, although it's only one quarter of experience, Japan recently experienced 4Q GDP growth of 1.2%, quarter over quarter, or 4.8% annualized. As you already know, the 4Q US GDP revision up to this point clocked in at 2.2%. Japan is in very big contrast moving in the opposite direction for now. In fact, among the major industrialized countries, the 4Q Japanese GDP number puts it among the fastest growing. Again, we'll see how this all works out ahead, but this is a big change for Japan if 4Q is in some way signaling even modest economic acceleration ahead. What has driven recent Japanese economic performance? A big help has been a weak Yen. In recent weeks, the Yen has been resting not too far from lows of the last four years. A big boost to Japanese exporters. Second, although this has been the case for many moons now, economic growth in greater Asia, and China specifically, has continued strong. Important in that Japan is a large exporter to Asia, and number one to China. So goes Asia, so goes Japan? This is not to be dismissed long term, despite the fact that the global economy of now is still quite dependent on the US consumer, but certainly won't be forever. And finally, both business and consumer spending was strong in Japan for the recent quarter. If something even bordering on moderately strong consumer spending turns out to be an occurrence other than a one-off quarterly event, that would be an important tell. All else being equal, a nice set of infrastructure circumstances for a potentially continued move higher in Japanese equity prices, heightened global equity market jitters of the moment aside.

But there are a number of macro issues that could either enhance or detract from the simple economic drivers of Japanese corporate earnings, the macro economic environment in the country, and ultimately stock prices. The first is M&A possibilities. We've been very surprised that we have not seen a good deal more headline press regarding the fact that starting in May of this year, "triangle mergers" will be allowed in Japan. In very simple terms, it allows foreign subsidiaries operating in Japan to use parent company stock to fund acquisitions. Let's face it, there are plenty of foreign companies doing business in Japan, as there are foreign entities with subsidiary operations in the US, and many other major economies. This opening up of potential M&A activity should express itself on two fronts. First and most obvious is the possibility for foreign acquisitions of Japanese companies. Clearly, Japan is one of the few countries that has not already been picked over in the evolution of global M&A. An area of potentially low hanging fruit in terms of operational rationalization, balance sheet leverage, etc.? In a word, yes. Secondly, and directionally coincident with the possibility that foreign driven M&A will act as a positive macro support to Japanese stock prices, is the possibility for Japanese companies to put themselves together as a preemptive or defensive response to this very important change. Clearly, either way, it's a broader positive for Japanese equities. Ironically, the weak Yen, which has been a support to the revenue and profitability of Japanese exporting companies in the recent fourth quarter, is a double edged sword in that it enhances the acquisition attractiveness of Japanese companies vis-à-vis total acquisition cost by a potential foreign acquirer. The cheaper the Yen, the more attractive Japanese companies become in the global sphere. In one sense, for Japanese corporate executives, the current level of the Yen relative to major foreign currencies is both a gift and a threat. And importantly, as you know, the Yen is one very big key in the global liquidity/credit cycle vis-à-vis the carry trade. More on that in a minute.

Why is the potential for opening up foreign acquisitions of Japanese companies important? We believe the primary bottom line rationale is that it represents change at the margin in terms of potentially heightened focus on shareholder value enhancement and corporate capital allocation. We certainly do not expect a flood of acquisition announcements as May dawns, but this may very well mark the start of a process of enhanced focus on profitability and shareholder returns among the Japanese corporate sector. As we've said too many times over the years, change at the margin can be quite powerful.

So let's stop for just a second and start adding up a few facts. First, we already know there is more than plenty of global capital roaming the Earth looking for a home, or at best a parking place for some period of time. Secondly, we already know that in large part excess capital has helped compress real rate of return possibilities in any number of investments relative to historical precedent, as it has likewise lowered risk premiums to near historic lows, changing the risk/reward profile of many asset classes in its wake. Japan opening up M&A will certainly create new investment opportunity and will attract global capital of some magnitude searching for returns greater than can be earned in already overcrowded global asset classes. If we step back and very simply and have a look at the long term chart of the Nikkei, we believe it's pretty darn clear that the financial markets are not only beginning to price in this change, but may in fact be showing us that the next leg of the recovery in the Nikkei is in the offing.

As we mentioned in the chart below, prior to action early week, the Nikkei price level stood at a percentage differential above it's 200 month MA not seen since 1997. You know that we have argued for years now that the 200 month MA is a very important demarcation line for the Nikkei, first acting as support in the initial post peak descent, being tested as the years progressed, and never being sustainably pierced to the downside until 1997. But from what was to ultimately be the sustained break of the 200 month MA, the Nikkei dropped another 63% to its final bottom in early 2003, when the great global central banker induced reflation began. Although we may be wrong, in our minds, a sustainable break of the Nikkei to the upside above the 200 month MA will be quite the important tell for the ongoing longer term cyclical bull in Japanese equities. Is the current break to the upside the real deal? As you know, we're going to find out dead ahead. And it may be very important if the 200 month MA can hold amidst a touch of global equity market upheaval, shall we say.

To be honest, we would not be surprised at all if the answer to that question is yes given the changes that lie directly ahead for Japanese corporate circumstances within the global corporate environment. If indeed Japanese equities in aggregate have embarked on the next leg of their longer term bull market journey, what can we expect as price targets to focus upon looking forward? Trying to remain conservative, the long term chart of the Nikkei shows us the next technical resistance range lies in the 20,200-20,800 area of the Nikkei. From current levels that's a modest double digit price appreciation target range. Are we shooting for the moon here? Not at all as we simply hope for one step at a time. Risk, of course, especially near term, is that we experience a bit more rough and synchronous global equity market waters.

What could go wrong ahead and what other factors do we need to take into consideration when assessing the prospects for Japanese equities? As always, we need to be on the lookout for the interplay between politics and financial markets, and maybe more so when this applies to Japan near term. We all know that the of the moment issue right now is the potential for further BOJ (Bank of Japan) interest rate hikes. The January pass taken by the BOJ on leaving short term rates unchanged was in very large part motivated by politics. But the February quarter point hike in short rates by the BOJ was in good part necessary to maintain credibility given the perceptual strength evident in the recent GDP report. From our standpoint, the BOJ lost credibility in a big way with the last pass on rate hikes. They would have compounded that problem had they again passed in February.

Getting Carried Away?...Surrounding this whole issue of recent strength in the Japanese economy, the desire by Japanese government officials to move slowly (maybe that should be characterized as glacially) on monetary policy and avoid any and all chances of heightened deflationary potential, combined with the need for the BOJ to ultimately project credibility, is probably the largest of global financial market 800 pound gorillas we can think of - the Yen based carry trade (quite simply the borrowing in low cost Yen and reinvestment in alternative currency higher rate of return global asset classes). A circumstance clearly brought to the fore this week in terms of what the Yen carry trade has the potential to unleash in terms of short term volatility. Without going into a lengthy discussion of this issue as it is more than well covered in the broader financial community, suffice it to say that the Yen carry trade is an absolute key to the global credit cycle of the moment. A credit cycle underpinning more than a fair amount of global asset inflation over the past decade-plus as well as contributing to the dramatic lowering of risk premiums in many a financial asset class. We can assure you that the global central banking powers that be are critically aware of these circumstances. Moreover, Japanese institutions themselves have been big beneficiaries in this global liquidity expansion scheme in the modern day environment. Someday, somewhere, the Yen carry trade is going to turn on its benefactors. And given the enormous one-sided tilt in the carry trade arrangement, even partial unwinding of this "trade" could play havoc with many a financial asset price for a time. But, as always, the question is when? Let's try to be realistic here; will the .25% rise in Japanese short rates now spark global financial market Armageddon as a result of this monetary baby step? We doubt it. In like manner, do you really believe Chinese officials, despite comments made earlier this week that supposedly lit the downside activity, would willfully attempt to implode their own equity market and simply sit back and watch it all happen? No way. We know that many a G7 spokesperson has sounded caution over this issue in the recent past. We also know many a global mover and shaker brought up the growth in global financial derivatives as a focal point at Davos recently. But does any central banker really want to see the golden goose of credit and excess liquidity driven asset inflation killed off? Not on your life. It's the markets themselves that will most likely actually initiate the evil deed at some point. Probably when it's least expected.

Maybe the key here is simply to watch the Yen and its response to monetary policy changes in Japan, if any near term. Again, we doubt the 25 basis point increase in short rates is going to cause the Yen to immediately rocket skyward, although some type of short term upward reaction is very possible. We believe the real problem for the carry trade would come if the G7 were to continue to be very vocal and ultimately put real pressure on Japanese authorities to raise rates. It's clear the Euro area is feeling the pain of an expensive Euro relative to the Yen. Euro leaders are certainly none too happy about present foreign exchange cross rate circumstances. Likewise, a carry trade problem could easily be born if the BOJ were to attempt to ratchet up market expectations regarding future monetary policy tightening (jawboning), as their past actions have neither been forceful nor strong, implicitly leaving the green light for carry trade activities shining brightly up to this point. Very quickly, let's have a look at what the charts are suggesting to us at the moment. Because when it comes to the Yen, we rest at a bit of a critical juncture right here.

First the weekly chart. What's clear is that during the last four weeks the Yen has been dancing near the lows put in during late 2005. I've marked the bullish engulfing candle put in a few weeks back, probably in anticipation of the BOJ rate rise decision. Hence, short term, we should be ready for anything, and a bit of further upside would not be surprising at all.

But as we step back a bit and look at the important longer term, the Yen is sitting on a very meaningful rising lows up trend line at this point. A meaningful breakdown below this line from here would only encourage the lopsided carry trade circumstances of the moment and most likely help to drive the global credit cycle to ever-higher heights. But what is certain is that over the intermediate term, the Yen is going to decidedly break out of the very long term contracting triangle or wedge formation in one direction or the other. A most important event for the future of Yen based carry trade activities indeed. We'll just have to see which direction ultimately dominates and act accordingly. So now we have two triangles to watch, one technical as portrayed below, and one fundamental - the triangle merger opportunities.

The Yen and dollar relationship is not the only relationship of the moment at an important technical crossroads. The Yen and Euro cross rate relationship is likewise at or near very long term key resistance as is clear below. It would sure seem that some type of bounce in the Yen relative to the Euro is in order, but we'll have to see how this plays out. Again, could the BOJ monetary decision for February be the spark to at least a short term Yen rally relative to the Euro? You bet. We'll know soon which way the Euro/Yen cross rate winds will blow.

So after this little tangential pit stop in the land of Yen carry trade commentary, let's complete the circle back to Japanese equities. How could the future direction of the Yen influence Japanese stock prices in aggregate? Although we are in no way attempting to be cheerleaders, alternative outcomes for the Yen, whether driven by monetary actions or carry trade influence, could be positive in either direction from a longer term standpoint. Here's the thinking. First, lack of any further BOJ monetary action near term may indeed keep the Yen soft relative to foreign currencies. Under this circumstance, it would be important to watch for a break of the Yen in the charts above to new lows. This would be quite meaningful, as we'd be witnessing very important long-term technical breakdowns. That would generate a lot of attention. Again, as per the triangle merger opportunities to come that we described at the outset of this discussion, a soft to weaker Yen makes Japanese acquisitions all the more attractive to foreign acquirers. This surely can't be lost on the BOJ and Japanese politicians given their provincial thinking. Academically, a macro positive for Japanese equities. Alternatively, IF the Yen were to rally for any reason, monetary policy, carry trade unwind or other being the driver of that appreciation, academically an appreciating currency attracts global capital for investment purposes, all else being equal. Would this happen right away? Probably not. An appreciating Yen that dented the carry trade may indeed drive many an asset price south for a time based solely on the need by those involved with carry trade activities to limit losses. Remember May of 2006? Of course you do. But a rising Yen is indeed an academic positive for long duration Japanese assets. And what are more long duration than stocks? Not much.

We have one final thought on Japanese equities that may seem a bit of a stretch, but bear with us here. We all know that China is literally swimming in foreign currency reserves at the moment, primarily dollars. We also know that China has stated many a time as of late that they intend to diversify these reserves. Okay, here it comes. Would it make sense for China to invest in Japanese equities? In other words, would it make sense for China to invest even a small portion of its foreign reserves in the very companies that are the largest foreign goods and services suppliers to China? (Remember, the numero uno importer to China is Japan). We're not so sure this isn't the very destination for some of China's excess reserves at some point, especially under any scenario of short term price duress. Yet another potential bid under Japanese equities to come? It sure could be. Certainly China will not benefit in a really big way from the change to come in Japan allowing triangle mergers as will other major global corporate citizens domiciled in the US, Europe, etc. who've been operating in Japan for some time. But there's nothing to stop China from investing foreign currency reserves directly in Japanese equities, not only to gain exposure and greater corporate equity ownership in the Asian economic bloc, but also to participate in what may be a firmer tone to come in the Japanese equity market longer term. Nothing like owning a piece of one of your largest goods and services suppliers to create co-aligned interests, now is there? It's just a thought.

So there you have it. A quick of the moment update on what we believe to be some of the key longer-term influences on Japanese equities. Again, we're a bit surprised the triangle merger issue has not gotten greater airplay in the mainstream financial press. We would have guessed that the climb in the Nikkei above the 200 month MA recently would have heightened attention on Japan, especially after its glaring nominal investment return underperformance in 2006, as excess global capital/liquidity continues to hunt for unexploited opportunities. But it's clear that global consensus perceptions of Japan are a low rate of return, slow growth economy. The last time we checked, financial investments are often well placed when expectations are low. But in today's world, long-term only investors need apply.

Is the volatility experienced in global equity markets this week the start of the "big one" (a very meaningful equity correction)? We wish we knew, although what it clearly reinforces in our minds is the incredible synchronous movement in total global equity markets of the moment. We're certainly not suggesting anyone bet the ranch on Japanese equities right here, but rather make sure this asset class is included in the proverbial shopping list when global equity "inventory blow out sales" occur.

Base Jumping...While we're on the subject of Japan, a very quick check in on the current dynamics of the Japanese monetary base. You'll remember our rather ongoing coverage of this phenomenon last year as Japanese authorities acted to contract the Japanese monetary base in a very big way. You'll also remember that the initiation of this action in Japan coincided almost directly with the initial drop in global financial markets as well as a number of commodity classes last May. As is clear below, the absolute contraction of the monetary base has stopped for now. We now stand at aggregate levels last seen five years ago.

On a year over year rate of change basis, the numbers continue to look very bad, but the damage has already been done. As we move into the summer of this year and assume no more monetary drain in Japan, the year over year growth rate numbers will again turn flat to positive by default.

So what might this mean for Japanese equities? While not necessarily a wild and exciting positive, it's rather a lack of what has been an important negative that's the meaningful point. Again, the Nikkei was probably the worst performing major economy equity market in 2006. And we believe a big piece of the reason behind this was the contraction in domestic monetary aggregates last year. That will be a big prior year negative that is absent in 2007. Is the lack of a negative a positive? Personally, we're more than willing to give thanks for small favors.

Market Observations
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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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