Euro-Yen at the Eleventh & a Half Hour

What are nation-states to do when markets imperfectly reflect the state of the world consistent with longer-term equilibrium? Witness the Japanese Yen vs. The Euro in the accompanying graph. What are we to make of it?

The market, according to pundits far and wide, ostensibly is focused on "interest rate differentials", and the forecasted rate of change thereof in the immediate period. Employing this line of reasoning, it would seem that the market is "acting rationally" eschewing Yen in favour of Euro's. In earlier days this might be wholly understandable since cycles might be distinctly out of phase. But globalization has changed this, increasing economic correlation and business cycle synchronization. Sure fiscal policies differ, and demographics might be divergent. But the logical question to ask is: Why might the European Central Bankers believe that 4% rate of interest is imminently appropriate, whilst the BoJapan's boffins (& MoFo's) believe 1% is too high?

Japanese asset prices are rising smartly - both property (commercial & residential)and shares. Corporate profits are surging. Capital investment increasing. Orders robust. Exports surging. Unemployment low. Government deficits large (>5%GDP). All the above are sure signs that things are pretty damn alright, irrespective of 0.5% core CPI still apparently deemed too low. Europe on the other hand, has less than 3% GDP fiscal deficits, much higher, but decreasing unemployment, surging asset markets, especially commercial and residential property (making some believe there is a bubble), growing private-sector debt, growing capex, roughly balanced trade accounts, and inflation that when incorporating asset prices, is growing and too high for policy makers to countenance.

So why with all this slack in employment, is inflation rearing up in Europe, but not Japan? Why are the Europeans more concerned about inflation or the Japanese with >5% fiscal gaps and near-ZIRP, not more puzzled by why with loose fiscal and loose monetary policy and rollicking asset markets, they are not generating more inflation at home? And if THAT combination of events is not generating goods-price inflation at home, would tighter monetary and fiscal policy really have a negative impact? And, if so, would this be bad for a nation that is is generating incredible dollops of income on overseas assets and FDI?

I think that what markets are not expressing, (rightfully since pissing in the wind is unpleasant in the best of times)) is that betting against the central bank and authorities of the world's second largest economy is a "mugs game". For the the world's central banks - at the moment - are working at different purposes. The US FRB is spinelessly schizo from dual irreconciliable mandates, erring on the side of soft money. The ECB is independently pursuing its mandate, it too erring on the side of soft money, though helped enormously by the saner fiscal policies, forward-thinking energy policy & taxes, and thankfully more balanced trade account, and manufacturing sectors. The BoJ, however, sits alone at the opposite pole to the ECB: politically compromised to TeamJapan, cynically selfish global citizen insofar as they maintain a ZIRP policy that matters not in the least to Japanese demand for credit, but which insures the YEN will be the global funding currency of choice to offset their surplusses and insure that TeamJapan losses not an iota of competitiveness to their Asian peers and would-be competitors. THAT is why the yen has deteriorated over the course of the past four years. THAT is why I loathe the BoJ's inaction, and the MoF's continued demaoguery regarding the impact of higher rates, for the only real impact of higher rates would be prevent the YEN from being the financing currency of choice for global carry, resulting in a higher Yen, resulting in lower corporate profits and potentially deflation of the benign adn unpernicious kind that results from productivity gains, plateuing demographics, and a geographical location adjacent to the largest deflationary force the world has ever seen.

China bears some blame here. For China, rather than be accumulating dollars, should be selling dollars and buying Yen, driving the Yen/Euro and Yen /dollar towards equilibruim amongst the crosses, and preparing for what the eventual acscent of the RMB (and the GCC currencies) relative to the entire OECD currency panpoly.

Bully Steals Candy From Baby

So American carpetbagger, Steel Partners, has managed to extract tribute from another Japanese management, in the form of Nissin Foods (TSE Code#2897) offer to purchase Myojo's (TSE Code#2900) shares from any and all comers at a heft premium to an already ramped-up market share price. Steel will undoubtedly tender. Nissin trumpeted the transaction benefits of a rather nebulous-sounding tie-up (surely meaning creation of a noodle cartel or price fixing oligopoly). But in their statement, they also unashamedly described their actions as protecting the many and varied Myojo constituents such as suppliers, customers, employees and management.

Not content to "cut & run" with the profits, nor satisfied with the greenmail gains, Steel reported today a 6% stake in Nissin itself, apparently as a result of the sub-optimal move of buying shares at a premium, but not taking the company over.

Greenmail IS effective in Japan. However, the Japanese will not continue to be extorted forever. What they (they being Japan Inc.) should do is let Steel actually succeed in one or so of their tenders since Steel has no strategic business rationale as cash acquirer, not to mention a probable shortfall in capital to actually finance the tender(s). It is a classic case of "be careful what you wish for". Let them, in the process of shaking down management, actually gorge themselves on a couple of chunky (but hard to digest) morsels (already ramped with expensive valuations) and see how they enjoy rolling up their sleeves as sole owner, or whether or not they have a trade buyer lined-up in the event of success. For the best way to deal with a bully is to call him out and embarass him (or her) in front of their peers for all to see their hollowness.

Could Japan stomach a few corporate sacrifices? Perhaps they should countenance such an offering to Steel, and then let labor and government ministries go wild and harass them thereafter as a not-so-subtle message to copycats to think carefully. For if they let Steel achieve even a modicum of success shaking down the system, there will be no shortage of imitators shaking up the share registers of listed companies something that would certainly NOT be in the interests of management, nor many other constituents, or even longer-term affiliated investors where shorter-term profit maximization is not at the top of the list of ownership objectives.

Is There Really a Goldilocks?

Some things to ruminate upon:

1. What's the outcome of a tug-o'-war between a falling dollar and Roubini-esque property-led slackening of US domestic demand, and the interaction of the two, upon the dollar price of oil.

2. Ponder whether US rates can survive in their current purgatory-like trading range once the markets smell dollar blood?

3. What is the probability of a genuine Goldilocks scenario including lower energy prices, muted inflation, natural correction in US & global imbalances without contractionary policy and outcome?

4. Could it be that Historical Cap Rates in US Commercial Real Estate and residential housing were, historically speaking, too low, and we are witnessing not a "bubble" nor "flight to hard assets" but simply a re-rating or semi-permanent state-change to higher (albeit sustainably so) valuations ??

5. Will anyone muster the courage to "call out" the BoJ & MoF for their not-so-benign-neglect in letting the Yen slide by >35% vs. the Euro since 2002?

Hey Joe! Me so pretty.

What I have to say won't take long:

Japanese stocks, excluding the whimisically thematic, the detritus, and the overly-glamorous, are remarkably cheap in comparison other assets. Factor in the embedded in-the-money currency appreciation option (for non-Yen-based investors since the BoJ will eventually relent), the oligopolistic, or in many cases, near-monpolistic nature of many of their edxport specializations, the low multiples to the hard (and increasingly scarce) underlying assets, as well as in relation to forecast earnings potential, free cash flow generated as well as relative to enterprise value, not to mention relative to replacement value, tossing in the meaingfully large dollops of accounting conservatism (i.e. significant R&D & Advertising that depresses current earnings in favour of future earnings), the benefits of industrial policies and corporate relief that result from national socialization of pensions & healthcare, and one has a compelling case for the shares of such enterprises hedging much monetary devaluation, whilst offering diminished risk should things not really pan out as currently expected.

Skeptics (and those who are, if not short, not long) will chime that there is no "catalyst", but this is untrue. The catalyst is rising asset prices, global relative valuation, continued global economic growth, and no pullback in China until after the 2008 Olympics. Yes, there remains issues for the really meek: transparency & accounting integrity, liquidty, stock supply overhangs in the hands of government, reduced shareholder rights and the cultural heeding of multiple constituencies that have profit-diminishing attributes during slack times, and the effect of dollar devaluation upon competitiveness.

All that and current index-price softness notwithstanding, relative to many other assets, they remain attractive, and if nothing else, will soon (and again) attract buyers - portfolio investors, pension funds, domestics, and petro-dollar earners - that will provide, at the very least, a quick turn with attractive risk v. reward to the bold, though probably larger and more sustained gains over the ensuing 12 months.

Optimism or Cynicism ?!?!

Question:

Is the fascination for commercial real estate, infrastructure and other hard assets a cold and calculating appraisal of the prevailing political economy that yields a high-probability scneario for more of the same: low interest rates, continued fiscal expansion, yet more current account, trade deficits & industrial hollowing giving way to further asset-price inflation WITHOUT limited imported-goods-price inflation or an interest-rate or currency accident??

Or is the continued run-up in asset prices simply the so-called savings glut and its attendant late-cycle cascades, in combination with what are currently low real interest rates combined with FX & interest-rate stasis, that is causing the herd (even the smart herd) to perhaps myopically "use it or lose it"??

My own money is [wrongly, to date I must admit] on the latter. Though other historically prescient investors have shyed away from the party (LA's Colony Capital Leucadia's Steinberg, Baupost's Klarman, etc.), today, the ranks are joined by Sam Zell (Equity Office Props), and more recently, David Geffen (who dumped a significant chunk of his art collection). While betting against either Blackstone or Carlyle hasn't, in aggregate, been extraordinarily rewarding, with the frenzy and prices-paid along with assumed leverage accelerating, one would be forgiven for wondering whether this stampede into large-scale leveraged asset acquisition is a bold statement of unbridled optimism or an ultimate statement "to be short paper & long assets" because the end of the BWII regime is nigh. Comments please!

Saturday's Thoughts

"The optimist proclaims we live in the best of all possible worlds; and the pessimist fears this is true."
- James Branch Cabell in 'The Siilver Stallion', 1926

"The liberals can understand everything but people who don't understand them."
- Lenny Bruce

"Conservative, (n.): a statesman who is enamoured of existing evils, as distinguished from the Liberal who wishes to replace them with others.
- Ambrose Bierce

"Credit...is the only ennduring testament to man's confidence in man."
- James Blish

"The cure for admiring the House of Lords" is to go look at it"
- Walter Bagehot

"It is easier to fight for one's principles than live up to them"
- Alfred Adler (1939)

"Democracy is the art of saying "Nice Doggie" until you find a rock"
- Will Roger

Republican Congress Poetry Corner

(with apologies to EJ Thribb aged 11-1/2)

So Farewell
Then 109th
Congress

Your Mandate
has been
Iraqified,
Abramoffed,
and Foleyed.

Gay Marriage
and Right-
To-Life Bans
Thankfully Unrequited
like Unexploded
Cluster Bombs.

"Everyday Low
Prices"
was your
Catchphrase.

Parochial Greed
and
Total Utter Disregard
For The Public Interest
is Your Legacy

What will you do
now?
Cleaning latrines
is far
too skilled.

'Tis a Shame
My Taxes
Will Pay
Your
Pension.

Sadistic Narcissistic Rally

The Bloomberg News headline reads: "US STOCKS ADVANCE ON PROSPECTS OF POST-ELECTION GRIDLOCK", which strikes me as rather, well, disgusting. For, so the logic goes, with gridlock comes more of the the same. Essentially, more large budget deficits, no new taxes, no new energy taxes, no energy policy, no universal healthcare, more military spending, no pharmaceutical regulation, no attempt to rectify international imbalances, and certainly no policy initiatives to attempt to deal with any of the structural risks to international monetary system. It does mean, more inflation, continued negative real interest rates, all of which [for the immediate moment] is the perfect environment for stocks, not to mention all other assets, hard or soft. Under the Gridlock scenario, optimists can look forward to the housing slump being rather shallow for house prices in nominal terms will not fall very much, even if turnover drops. And as inflation accelerates (though interest rates lag with the Fed squarely behind the curve), housing inventories will be consumed as they begin to look attractive once again.

All which conjures images of sleazy "Cock fights", the Gladiators in the Forum of Rome, "bare-knuckle-boxing" or Smash-up Derby" where inexplicable sadism is rife and the seeming focal point of spectators' (or in our case Stock Traders & Investors') maccabre pleasure. Keep an eye out for Emperor Nero, for his is surely lurking nearby.

The Forest and "Cheap" Trees

I will tell you a personal secret: I become rather anxious when asset prices rise far and fast. This is partly because I hold the opinion that coordinated asset price rises are somewhat self-extinguishing in an environment of already leveraged households, already appreciated assets and rather largely indebted governments. But it is also because I hold some non-hard asset financial assets (because of what I believe to be the elevated probability of the above), and so become relatively poorer with each additional upwards vault. And as behavioural finance researchers have shown, it is indeed one's relative performance that produces anxiety.

And as I look around today, I see all asset prices doing moonshots: Global shares of virtually all sectors; Credit spreads at cyclically narrow levels; real estate of all manner in most countries at post-war peaks in terms of affordability multiples, while cap rates for commercial real estate the world over are near all-time lows. So dire is the cap rate conundrum, and perhaps so certain that the rates won't go up and that the only way to earn an incremental nickel is to lever up that Morgan Stanley recently launched the largest aggressively-leveraged real estate Fund ever seen by mankind. Art from van Gogh, Klimt to Jackson Pollock is valued in the triple-digits of millions, while even some mickingly absurdly modernist art is changing hands in the millions. Undeveloped land is raging. Media content such as recording and film libraries too are garnering impressive valuations, as is agricultural land and orchards. Infrastructure is booming (also with copious amounts of leverage). Antiques, too, are on a rampage, as anyone who's watched Antiques Roadshow can attest. Stamps, coins, curio collections of dubious pedigree, vintage cars, sports memorobilia all gallopping. Commodities of all sorts from precious & metals to softs and foodstuff are up up up.

But my realm is Japan, in general, and Japanese public equities in particular. And here, too, I will share another secret with you: despite raging asset prices the world over in every asset class, in virtually every region (except perhaps North Korea, Zimbabwe & Moldova), slightly more than 30% of listed Japanese public companies are trading south of stated "Book Value" as reported at the end of the latest fiscal year. This is approximately 1225 enterprises out of perhaps approximately 3800, not including those with negative book values. By way of comparison, the US market is, as of last night, sporting nearly 250 listed companies out of nearly 6,800 (using a $50mm market cap cut-off to avoid Chap-11 reorgs). This is a miniscule 3.7% of US listed companies trading sub-book.

Now there remains some caveats: some of these companies are really shitty, detroying shareholder value as prodigious rates. Others are merely illiquid - so illiquid that it might an entire year to acquire but a few percent of the shares outstanding. Another calss are small...in some cases really small...so small that many a hedge fund manager could buy them with their credit card! (ok this is an exaggeration). Yet others have small floats and /or concentrated ownership that they are little more than listed holding companies, and being a shareholder in a Japanese enterprise is trying enough, even before having to countenance being a minority shareholder in a Japanese Company.

To be fair, American companies all suffer from many of the same shortfalls. And perhaps, because the "best and brightest" and the "smartest guys in the room" are engaged in finance rather than engineering, the market is more picked-over, so the probability that a company that is trading sub-book is, in fact, defective is much higher than in Japan, where it is likely to be suffering from inattention, insufficient affection, and general benign neglect.

Nevertheless, 1225 (33%!!) is a large number, so this patch of forest must contain, if nothing else, a lot of assets. And since assets are such the rage these days, the question arises as to how long such potential bargains will remain, especially with money supplies the world over run amok, real rates near zero or negative on any kind of realistic inflation measure NOT calculated by the US BLS?

So perhaps next week, I will introduce a new investment fund called "Assets-'r-Us", and we will blindly buy the entire 100-acre wood, dregs and all, under the mantra: "I don't know, and I don't care, but if it's an asset, lift the offer....". Of course, these assets perhaps should be cheap, and the anomaly could very well be that all other assets are poised to collapse under the weight of their own prices and, the tighter monetary polciy that is imminent, and the contractionary effect of the inevitably deterministic rise in US energy adn income taxes.

Momentum Perfection

As we approach the end of the 2006, I will take the opportunity to exclaim how uncharacteristic certain factor returns of the Japanese equity market have actually been. As a result of the world upside-down, cynics would be forgiven for being optimistic about cats relationship with dogs, or Palestinian hopes for a fair peace settlement with Israel, but nonethless, in Japan, the market where the momentum phenomena, so puzzling to efficient-market theorists and so prevalent elsewhere, which has been absent for the better part of two decades, has manifested itself in picture-perfect fashion over the trailing 12-month, much to the ire or reversion-oriented investors.

Apologies for that last breath-consuming near run-on-of-a-sentence, but perfection is perfection, and just as aesthetes are compelled to laud good design, so I must give credit where credit is due. As recently as this month, the godfather of market efficiency, Dr Eugene Fama was commenting in Financial Engineering news:

FENews: Your view is that the anomalies researchers have discovered – such as calendar patterns, the January effect and other relatively predictable relationships – are not anomalies that people can consistently profit from, right?

EFama: A lot of them disappear on closer examination. They’re not like M&Ms – they do melt in your hands. They are statistical fallacies. The one that gives me problems is momentum. The phenomenon shouldn’t be there.

FENews: Has the presence of momentum in asset prices increased in recent years, as a function of retail investors?

EFama: Nobody can explain it. It was a little weaker in the 1930s and 1940s than it was after that. It never existed in Japan.

So to see the returns to stereotypical naive "momentum" in Japan, as evidenced by Jegadeesh & Titman's ("J&T") seminal 1993 paper "Return to Buying Winners & Selling Losers" line up "just-so", is really nifty. In the 12 months-to-date, the decile returns in Japan in sympathy with J&T methods:

Momentum 1-month = - 8.9%
Momentum 3-month = + 7.7%
Momentum 6-month = +12.8%
Momentum 12-month = + 9.2%
Momentum 36-month = -18.4%

As you can see (as most US quantitative managers understand), short-term reversion is prevalent intermediate reversion is the rule, long term reversion remains the trump. And note that more complex and sophisticated momentum strategies (sorry, but those are proprietary) have yielded commensurately better returns (as one would expect) while the same holds for the more sophisticated flavours of reversion in the short & long frames (again these are closely held).

Now one can ask "why?", as I have done here on a number of ocassions. And my answer would be (not necessarily in any particular order of explanatory power):
(1) Convergence of investment methods of styles;
(2) return of foreign investors to Japan where they now dominate;
(3) investor concentration enhances the sheer ability of the largest marginal buyer (e.g. Fidelity, SPARX, Cap Research) to purchase sufficient percetage of stock from free-floating market to elevate and maintain a prices on the tails. Periodic liquidation of such position invokes the flip-side;
(4) Increase in "feedback-trading" (pro-trend & passive strategies) as a percentage of overall trading strategies.

Will this evolution to picture-perfection momentum become a permanent feature of Japan's bourse? The answer I think is a qualified "yes", so long as foreign investors remain present, dominant, and active, and such investment methods continue to be the by-product of the way the Global Fund Management Game is implemented & played.