Electronic Herd Thunders Through Japan

In my previous Nov 11th post "Confidence Isn't Everything" I entertain alternative explanations for why Japan has historically been characterised as a "reversion market". While there are significant constraints peculiar to Japan, I proffered that it it also likely to be influenced by "behavioral" factors, most notably the lack of "overconfidence biases" amongst Japanese investors for cultural-specific reasons.

This is hindsight however, and while this may explain the historic reasons for Japan's unwillingness to participate in the global momentum party, trend persistence (serial correlation of individual stock returns) has emerged as a potent factor in Japan. Is this a so-called sea change, or simply a syle speed bump en route to more reversion and disappointment? This question may only be answered ex-post, but one thing is clear: the emergence of momentum has accompanied the tsunami of long-only and hedge funds buying and selling (though mostly buying)Japanese shares.

Senior Equity Strategist Goro Kumagai discussed the rising importance of the individual on-line investor in Japan over the past few years. Account numbers have been steadily rising to more than 1.8 million accounts across the major on-line brokers. This, according to Mizuho's Kumagai accounts for more than YEN 1 Trillion in funds (~USD $9 billion). With an average account size of YEN 3.5 million (USD $30,000), and a fortnightly turnover (24x per year), this equates to YEN 200 trillion in turnover - almost double the YEN 100 trillion of annual institutional turnover on the TSE. Clearly they are a force to be reckoned with (or at least ignored at one's peril).

Which brings me back to this post's question: is this emergent momentum "the kind found in the USA which, to the contarian feels like being impaled upon hot rusty poker, or does it resemble the "good old days" of tha late 80's and 90's where speculators bought and sold "whisper stocks", or fashioned daily themes in response the prognostications of Nui Onouoe's buddhist toad? This was a time when long margin positions were systematically gunned due to their predictably low pain threshold and loss aversion and short margin inversions resulted in dizzying and elongated melt-ups with astonishing predictability.

But what if this electronic herd are a "new breed"? What if they are not salarymen playing the financial ponies (poorly, I might add), but financial equivalents of Yoyogi-park Elvis' that are fast becoming as sophisticated, tenacious, and coordinated as the US IBD momentum crowd? What if they are, in short, diverging from their historical stereotypes, and becoming overconfident like their US kindred spirits.

A larger and decidely different electronic herd, replete with overconfidence and self-attribution, and myopic loss-aversion biases, in combination with an increasing concentration of size at both hedge funds and large long-only complexes, would have a profound and disturbing effect upon the behaviour or Japanese equity markets.

In the same way global warming has (according to everyone except the present US Administration and a lone Scandinavian skeptic who has since been discredited) has laid the conditions for larger and more vicious tropical storms, these changes whereby speculators, hedge funds and long-only fund complexes tend towards the same positions stylistically - call them behavioural aligments - would result in an increase in consensus within the market. This is not the same as efficiency, since it's only temporary. This would very likely lead to be bigger, and longer accumulations and distributions, a greater stretching of valuation boundaries, and a generally dichotomous approach towards the selection of securities: "There will only be good stocks and bad stocks". In this savage and binary world, its wonderful if you're a "good stock" with some or all of the characteristics the market is desirious of, and it's lucifer's barbecue if you present the market with an earnings torpedo or anything resembling a temporary setback after which your only friends will be Brandes or Silchester. Once in a while, however, the god-awful piece-o-crap stocks will revolt - whether for a month or a quarter - and vault in an amazing, colon-cleansing path, while the "great ones" will revulse" for no apparent reason". Well, almost no apparent reason since hindsight might suggest it was because too many people were in the same place, at the same time when someone per chance yelled "Fire!"

The choices that this style-tyranny creates (or dictates for the truly fatalistic) for thoughtful portfolio managers, allocators, and trustees are at once both stark and grim. The thoughtful portfolio manager is forced to become like Louis Navellier and "Do what works" (Shit! I wish I'd thought of that). Game or be gamed! It's a tough choice, but being prudent or sensible, results in returns that feel little different from taking a big long piss into a strong headwind. For the allocator, often an intermediary her self, there is little advantage to going against the flow. She is not penalized for failing conventionally, but is chastised (literally!) for making a bolder call, and getting it wrong. Take risk, just don't get it wrong! And for the trustee, few have the latitude, the intelligence, or the incentive to step out onto a non-conformist limb like David Swenson - irrespective of the correctness or the upside. All this is to say that while there is little question where one "ought" to be, there is great question as to whether one, one's investors, or the trustees of one's investors can stomach it. And it is precisely this conundrum that will make the opportunity that much more rewarding. Eventually.

For style consensus, and less-than-justified valuation dispersion - particularly the kinds that are non-economically driven ALWAYS end in tears. The challenge to the thoughtful contrarian and the opportunist in this brave new momentum world in Japan is to insure that one gives a wide berth to the new style consensus so that one is around to play the game when the style gods are less agreeable.