Kass: Japan's Rising Sun
This blog post originally appeared on RealMoney Silver on May 2 at 9:26 a.m. EDT.
"You are all a lost generation."Last Monday, I lectured in Professor David Stowell's investment class (Wall Street, Hedge Funds and Private Equity) at The Kellogg School of Management at Northwestern University in Chicago.
-- Ernest Hemingway, The Sun Also Rises
Prior to the lecture, David shared with me his syllabus, and I noted that one of my favorite investment books, Barton Biggs' Hedge Hogging, was one of the two required reading books in the class. (The other required reading book was David Stowell's An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm.) I shared this with Barton, who was justifiably flattered by his book's inclusion in the course, and Barton passed on a memo he had just written about Japan.Barton's memorandum got me to thinking about Japan, and, after some further analysis over the past month, I have taken a long position in iShares MSCI Japan Index Fund (EWJ).
No country in modern history has moved so swiftly from worldwide adulation to dismissal or even contempt as did Japan, in a process that began more or less as the temple bells were tolling in the new year of 1990. In the 15 years that followed, amid crashing stock- and property markets, mountains of dud debt, scores of corruption scandals, vast government deficits and stagnant economic growth, Japan mutated from being a giver of lessons to a recipient of lectures, all of which offered recipes for its reform and revival. Those lectures, although received politely by a newly self-deprecatory Japanese elite, seemed to be ignored. The Economist, " The Sun Also Rises" (October 2005)As Barton put it in his note to me:
The experience of Japan over the last 20 years demonstrates how dangerous it is to allow deflation to take root in an economy burdened with a massive load of private debt that the debtors are desperate to pay down. The Bank of Japan's (BOJ) and the ruling party's errors compounded the deflation and a psychology of "don't buy now; it will cost less later" became entrenched. Prices inexorably fell, and paralysis of the economy and the political system ensued.Let me explain my rationale for buying Japan now:
- Since the devastating Tōhoku earthquake and tsunami on March11, the Topix has fallen by about 5% while the MSCI World Index has increased by over 5%.
- The condition of the Fukushima Daiichi nuclear power plant has been stabilized and a plan to realize a cold shutdown is now in action.
- The electrical supply outlook has improved. According to Goldman Sachs Tokyo Electric Power Company's electricity output by this summer should not force large-lot users to restrict electricity usage.
- The Japanese government is responding promptly with regard to policy stimulus. The Kan administration has submitted a first fiscal year 2011 supplementary budget, and a second supplementary budget is expected by the end of June.
- Japans' monetary policy is market-/economic-friendly. Base money growth has surged since the March nuclear accident. In mid-March, the BOJ increased its asset purchase program, and in early April, the BOJ announced a new loan program geared toward assisting financial institutions in their response to the likely increase in reconstruction funding demand.
- Economic dislocations caused by the earthquake have threatened near-term GDP forecasts, but I will remind readers that the U.S. stock market's generational low was achieved under similar economic uncertainty.
- The Japanese government appears to be implementing fiscal stimulus that is reasonable in scale and timely in policy.
- There is widespread optimism that the worldwide economic recovery will be smooth and self-sustaining -- as such, it could facilitate a meaningful improvement in Japanese exports.
- Finally, the post recovery future for Japan will hopefully accelerate reforms (e.g., free trade agreements). It might also lead to accelerated production diversification (and more M&A activity) and rising demand for alternative energy technologies.
Barton's Vision of JapanNow to Barton's most interesting observations on Japan's history of formidable accomplishments as well as his read on the (admittedly) existential and mystical side of the recent nuclear accident and its possible positive investment implications:
Though possibly farfetched, it is conceivable that the effects of the earthquake are analogous to "creative destruction" and could kick start the lethargic Japanese economy and end the long period of stagnation. Its consequences could also revitalize the political and corporate governance process that has once again demonstrated the overwhelming incompetence of the Prime Minister, the bureaucrats who really run the country and, finally, the careless and pathetic management of the major electric utility whose president had an emotional collapse.He goes on:
The earthquake damage and the nuclear disaster constitute an enormous supply shock to the Japanese economy, as electric power is rationed and ruined production facilities are shut down. Japanese companies have been de-leveraging by paying down debt, and loan demand has been nonexistent, but now companies are going to have to borrow money to rebuild. The earthquake should activate loan demand, and production shortages should narrow the output gap and maybe even trigger some inflation. I'm not into mysticism, but there is a mythology in Japan that the major earthquakes that have haunted and rattled Japan for centuries have presaged major cultural and social changes in this island
nation... whose culture is utterly unique. The 1855 Tokyo earthquake that leveled the city marked the beginning of the end of 200 years of isolation and a complex, rice-based feudalism with the emperor ruling from Kyoto called Tokugawa or Edo period. It was followed by a Japan more industrial and open to the world, and that fought and won a great sea battle with Russia. The 1923 quake signaled another new age with the rise of aggressive militarism and an obsession with Asian conquest that culminated in World War II. Ironically, the Morgan banks took the lead in underwriting large sovereign debt issues that financed the rebuilding and rearming of Japan. The Emperor two decades later remembered this assistance was reluctant to go to war against the U.S. because of it. Some Japanese who believe in this theory even argue that the devastation from the atomic bombing of Hiroshima and Nagasaki was like an earthquake and signaled the end of that tragic, militaristic era. They also maintain that a half century later the Kobe 1995 quake signaled the end of the postwar industrial boom, and heralded 20 years of recession and deflation. They maintain that in the decade after earthquakes, the legend is that the Japanese birth rate dramatically rises. As we all know, Japan's declining population and workforce have been a huge drag. It is not that earthquakes cause or bring change in and of themselves. Instead, they signal change. The Japanese island, the earth, the tectonic plates are speaking. The land is an integral part of the race, the nation, and the Japanese believe its adherence to cultural and racial purity causes its superiority. Think of the thousands of years when Japan and the Japanese were totally separate from the rest of the world. Even today, immigration is restricted and blocked. Read Shogun or the modern history leading up to 1941. The Japanese are a formidable race. After the 1923, earthquake they determined to build the best navy in the world. Their naval academy, Eta Jima (EJ), made Annapolis look like a summer camp for privileged teenagers. The EJ midshipmen were tutored by English instructors in table manners and making toasts. They were told they must always travel first class and must never be seen carrying packages. The academic, physical and seamanship programs were very demanding, and, above all, unswerving loyalty to the emperor, obedience and readiness to die in battle was instilled and enforced. Surrender was never an option, and captains went down with their ships. The midshipmen were also brutalized. The smallest infraction of a rule resulted in a beating and guard duty punishment. Every Sunday, freshmen stood at rigid attention in the yard for four hours and were slapped and pummeled by upper classmen. The physical training program was intense and unrelenting. British offices observing the curriculum questioned whether it didn't produce narrow-minded robots whose creativity and independence had been beaten out of them. Despite its Spartan regimen, Eta Jima had 30 applicants for every one accepted. Throughout, the Imperial Navy violence was employed to enforce discipline and blind obedience. Just as the samurai warriors of the past could kill an impudent commoner who failed to get out of their way in the road, a Japanese naval officer in 1941 was required to strike five times with his fist any enlisted man who failed to salute or who disobeyed a direct order. Petty officers on Japanese ships carried thin, but heavy, sticks called "spirit bars" with which they hit enlisted men who did not respond fast enough to orders. It is now accepted that by the late 1930s the Japanese had the best, most sophisticated navy in the world, with three super battleships and five aircraft carriers. The U.S. just got lucky in the crucial battle of Midway in 1942, and in addition, an operations officer on the Japanese flagship succumbed to sentiment and allowed his aircraft to be caught on the deck refueling. Incidentally, he had gone to Princeton instead of Eta Jima. The Japanese army was no different. Soldiers were expected to be able to walk 35 miles a day for weeks on end with full pack and equipment. They were conditioned to endure on a diet of rice and water and four hours of sleep a night. Young officers were trained to be aggressive and always attack. In fact, their field manual had no chapter on retreat. Japan had also developed an aeronautical marvel, the Zero, which was the fastest, most maneuverable fighter plane in the world. Ironically, the Zero was delivered from its factory by ox cart.
ValuationsFinally, let's now look at valuations. Most recognize that the Japanese stock market has experienced one of the most drawn out and pronounced secular bear markets in history. Here is a long-term chart of the Nikkei. click here.
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