Is the US the new Japan?: stock market implications

the Lost Decades

Today, I’m going to expand on yesterday’s post by writing about features of the “Lost Decades” in Japan that I think might be repeated in similar circumstances elsewhere.

Before I start, however, I want to make two points:

–I don’t think the US is the new “Japan”;  the EU would be a better candidate, in my opinion, based on its behavior toward its banks, its money policy regime and the way many countries intrude into the workings of their equity markets.  But I don’t think it’s anywhere close to being another Japan, either.

Instead, I’m reading the current downdraft in world markets as an adjustment to two realizations:

that economic growth in the US and EU will potentially be much slower in the next two or three years than in 2009-10, and

that no more government support for markets is forthcoming.

The removal of the implicit safety net is the bigger deal, to my mind.  I’ve been thinking–and writing–for a long time that the slow growth/high unemployment problem is a social and political one that won’t affect corporate profits much.  I still think so.

–To (my) Western eyes, the Tokyo stock market was a very peculiar place twenty-odd years ago.  Back then, the government was actively involved in controlling the stock market, in much the same way that governments typically control their bond markets.

For instance:

at times, Japanese brokers were not permitted to accept sell orders for domestic commercial banks–at least from foreigners.

Large amounts of trading were done in specially segregated trusts, to make it clear that the parties were not disrespecting one another by liquidating stockholdings established to cement business relationships. These tokkin “portfolio managers” typically worked in large smoke-filled rooms that housed scores of them, all trading off price movements posted on large electronic “scoreboards” erected along one wall.  No research, no portfolio planning–just trading on hunches or “hot” tips.

Women were legally barred from purchasing warrants (don’t ask me why).

If you want to see something really weird, read my post on tobashi.

Despite these unique quirks, I think there are aspects to the Japanese experience that I think would apply elsewhere.  And, of course, it’s always good to think out alternate scenarios, just in case they become more probable, or because you find your initial assessment was wrong.

Three  factors stand out to me:

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is the US the new Japan?

the question

That’s the question of the day for many stock market commentators.  Most are probably aware that Japan boasted the second largest economy in the world in 1989, and at the same time the world’s largest stock market by far.  The prevailing mood in the US back then was that Japan would soon eclipse us as #1, and we’d be left with selling our armed forces as mercenaries to the rest of the world to get foreign exchange (hard to believe, but true).

Yet, the following two decades saw only economic stagnation for Japan, with its economy long ago surpassed by China and its stock market shrunk to less than a quarter of its relative size.

What went wrong with Japan?

Most of those suggesting the US is starting down the same path don’t have a clue.

To my mind, having watched the Japanese economy and stock market for over 25 years, is that those in power in Japan deliberately chose to preserve the status quo–and the traditional semi-samurai way of life that that implied–over the “creative destruction” that would likely have secured a better economic future.  This stands in stark contrast to the behavior of the prior generation, which rebuilt Japan from the ashes of World War II.

There are parallels between Japan then and the US now.  But there’s already been one major difference in approach.  My guess is that Americans will continue to make substantially different choices than Japan did, but, trite as it is to say, it’s too soon to tell.

the parallels

–The most obvious–and possibly the reason for all the talk–is that both countries have extremely low nominal interest rates, which have failed to turbocharge either economy.

More than that, however,

–Japan experienced a substantial bubble in property and financial assets in the late 1980s, caused by reckless bank lending and regulatory neglect.  (In contrast to the American sub-prime housing bubble, which eventually collapsed under its own weight, the Bank of Japan ended that country’s period of speculative excess by raising interest rates).

–Like most nations, Japan believed in the innate superiority of its way of life.  Japan also believed it received special favor from the divine through the mediation of the emperor.

–The legislature was (and still is) dominated by money politics, with legislators’ influence in the Diet based on their ability to raise funds from special interests.

–Neither major political party had a relevant contemporary social agenda.  The Socialists, now the Democratic Party of Japan, opposed the use of nuclear power and drew their emotional appeal from the WWII bombings of Nagasaki and Hiroshima.  Oddly, the party also supported North Korea and pachinko parlors.  The anti-nuclear weapons platform later transmuted into anti-nuclear power.  The Liberal Democratic Party, the dominant force over the past 50 years, favored protection of domestic agriculture and policy support for export-oriented manufacturing–in other words, it maintained positions appropriate for Japan only as the developing country is once had been.

differences, so far

–Japan covered up its banking problems for a decade.  The government pressured (successfully) the banks not to call loans made to bankrupt firmsIn fact, it encouraged them to extend more credit, in the vain hope that time would heal what management incompetence, and sometimes corruption, had created.

The propping up of what became known as “zombie” firms had two very negative consequences:

it continued to degrade the financial strength of Japan’s commercial banks, and

it shifted sales away from healthy firms, weakening them as well.

–Through formal and informal means, the government discouraged mergers and acquisitions that would have brought new management into troubled firms. In particular, a series of new laws made it virtually impossible for a foreign firm to take over a domestic one.

–At the time the bubble popped in late 1989, about 10% of Japan’s workforce was employed in the construction industry.–an unusually high proportion for an advanced economy. Rather than attempting to retrain workers (by the way, a task made more difficult by Japan’s kanji-based written language), the Diet chose to launch a continuing series of infrastructure construction programs to keep these workers employed. Later studies seem to show that these projects had no lasting positive effect on the economy. They appear to have served mostly to line the pockets of politically connected companies, raise the national debt and delay the adjustment of the workforce to the new economic realities.

–Throughout this time, Japanese voters, who are generally highly economically sophisticated, remained surprisingly passive. Although the situation is a bit more complicated than this, voters tolerated LDP mismanagement of the economy for twenty years before voting for change. Unfortunately, the DPJ which replaced the LDP has proved as inept today as its predecessor was when it was briefly in power in the late 1980s.

–The Tokyo government snuffed out a nascent economic rebound twice during the Nineties, once by raising interest rates, once by raising taxes.

what about the US?

Will the US make the same errors as Japan? In a narrow sense, it’s too soon to tell. However,

the US has acknowledged its banking problems from the outset.

We can already see substantial merger and acquisition activity underway.

Certainly, “creative destruction” is regarded in a positive light in the US.

Also, I can’t imagine that American voters would be as tolerant of government ineptitude as Japan has been.

The more relevant question will likely be whether the new politicians voted into office will be any better than those voted out.

Tomorrow: stock market implications.


earnings surprisingly strong, sales a little light–the stock plunges: why?

strong eps, light sales

Sometimes the way that the mind of Wall Street expresses itself in stock prices strikes casual observers as odd.  A prime example of this is when a company (DELL is a recent example) reports earnings that exceed the Wall Street consensus handily, yet the stock doesn’t go up the way you’d expect.  Instead, it drops like a stone.  The market seemingly ignores the strong earnings and points to revenues as the cause of its unhappiness.

Seems kind of petty.

Is there any sense to this reaction?

Yes  ….and no.

the yes part

Remember, the growth stock investor’s mantra has two features:

–surprisingly strong earnings

longer than the market expects.

In situations like the one I describe above, it’s the assumed lack of permanence in the earnings gains that the market is making a negative reaction to.  The argument is this:

Companies make money either by selling more stuff, in which case revenues will rise, or by cutting expenses, in which case they won’t.  So earnings without revenues = cost-cutting.  Cost-cutting opens the door to two bad outcomes:

–sooner or later (probably sooner) the company will run out of expenses to cut and earnings will drop back to their pre-surprise level

–the firm may reducing crucial expenditures, such as research and development or customer service to an extent that future earnings prospects are harmed.  Therefore, earnings won’t just drop back to the pre-surprise level, they’ll fall below that.

the no part

The knee-jerk reaction that earnings growth without revenue growth isn’t a good sign will probably turn out to be right in the majority of cases.  But there can be instances where this is a mistake.

As I’m writing this, I’m struggling to find a plausible concrete example to illustrate what I’m about to say–which tells you (and me) something.

Anyway, it’s possible that a company is composed of a fast-growing, high-margin component and a slower-growing, lower-margin (or loss-making) one.  It may be that new products in the high-margin component are what’s creating the slow revenue, fast profit-growth pattern.  It’s even possible that the company in question is preparing to separate into two parts, either by sale or spinoff, in a way that will remove barriers to investors seeing the full potential of the growth component that the mature one creates.

for a positive market reaction?

For the market to have a positive reaction to strong earnings, light sales, I think three things are necessary:

–the company has to communicate clearly what the dynamics of the earnings situation are (it may have competitive reasons for not wanting to do this)

–professional analysts have got to trust what the company is saying and/or find confirming evidence, and

–investors have to be in a relatively bullish mood, so they’re willing to overlook the bearish signal and believe the bullish story.

 

 

two tricks of performance calculation arithmetic

measuring performance

The acid test of active management–both of our own efforts and of the professionals we may hire to invest for us–is whether they add value versus an appropriate index.  Picking the benchmark against which to measure results is a pretty straightforward task, though judgment issues do sometimes arise.  (For example, if all a manager’s outperformance of the S&P 500 over the past three years comes from holding a large position in Baidu (BIDU), the Chinese internet company listed on NASDAQ, is the S&P really the right index to be using?  But that’s a story for another post.)

What I want to point out here is a quirk in the way performance calculations are done:

–in a rising market, outperformance tends to look better than it really is;

–in a falling market, outperformance tends to look worse than it really is.

The opposite is true of underperformance.

in a rising market, underperformance tends to look worse than it really is;

–in a falling market, underperformance tends to look better than it really is.

Here’s what I mean:

Let’s take an example where the numbers are impossibly large, just to illustrate the point.

outperformance

We’ll suppose that on Day 1 of the measurement period the index is unchanged but our portfolio gains 50%.  At the end of Day 1 we’re 50 percentage points ahead of the index.

a.  rising market.  Suppose that for the rest of the year, our portfolio matches the market performance exactly and that the index doubles from Day 2 through the rest of the year.  How far ahead of the index is our portfolio for the year?

Your first instinct is probably to say “50 percentage points,” since we’ve made no further gains after Day 1  …but that’s wrong.  The actual outperformance is 100 percentage points.

If the index starts the year at 100, its ending value is 200.

If our portfolio starts the year at 100, we’re at 150 at the end of Day 1 and we double from there–meaning we’re at 300 on the final day, or 100 percentage points ahead of the market.  Whatever positive thing we did on Day 1 has been magnified by the rising market.

b.  falling market.  Let’s take the same portfolio, up 50% in a flat market on Day 1.  This time, let’s suppose our portfolio matches the index for the rest of the year, but that the index falls by 50% between Day 2 and the end.  How far ahead are we for the year?

Having seen a., you’re already going to guess that 50 percentage points is wrong.  …and 50 is wrong.  But what’s the right number?

Well, if the index starts at 100 and loses 50%, at the end of the year it’s at 50.  At the end of Day 1, we’re at 150, but we lose half that amount through yearend.  So we end up at 75, or 25 percentage points ahead of the index.

underperformance

Let’s start again with crazy numbers.  Assume Day 1 is the day from hell and we lose half our money in a flat market.  We’re 50 percentage points behind the index.

c.  rising market.  The market doubles from Day 2, going from 100 to 200 by yearend.  We match the market.  Our 50 goes to 100.  We’re 100 percentage points behind the market.

d.  falling market.  The market declines from Day 2 on, and drops from 100 to 50 by yearend.  Our 50 is cut in half to 25.  We’re 25 percentage points behind the market.

implications

There are all sorts of implications for professional investors, who tend to earn most of their compensation based on annual performance vs. an index.  You never want to get behind in a rising market, for instance.  Or, a falling market tends to compress out- and underperformance numbers closer to the index, so that’s the best time to play catch-up.

For the rest of us, the lessons are:

–don’t get too excited about the “phantom” outperformance that a rising market (2009, 2010) brings, and

–more important, a decline of 15% like the one we’ve been in will reduce your under- or outperformance by 15%.  Don’t think your stocks are suddenly doing better/worse than they are.  To see your real performance during the downturn, don’t check the year to date figures, check them from the start of the downturn until now.

NOTE:  If you’ve constructed a portfolio for a rising market, or if you were ahead year to date before the current decline began, you should expect some slippage in relative performance as the market sags.  Similarly, if your holdings are geared for a down market, you should now be seeing a pickup in relative performance.

How much relative gain or loss?  That’s another post-full.  A lot depends on the level of risk you’ve assumed and your skill in picking stocks.  But if you’ve battened down the hatches, you should be seeing at least some benefit.  If you’ve continued to keep a lot of sail let out (which is my usual position), you shouldn’t be surprised/dismayed by a modest relative loss.

 

 

 

I’m updating Current Market Tactics: part 2 of 2 on scenario-building

I’ve just updated Current Market Tactics.   If you’re on the blog, you can also click the tab at the top of the page.

Google’s takeover of Motorola Mobility: implications

the deal

Yesterday morning before the start of trading in New York, Google and Motorola Mobility jointly announced an agreement for GOOG to acquire MMI for $40 a share in cash, or about $12.5 billion.  The takeover price represents a 63% premium over MMI’s closing quote last Friday.  The parties have also agreed to a breakup fee of $2.5 billion, or 20% of the deal price (an unusually large amount)–and that MMI will operate as a separate division of GOOG.  The deal is expected to close late this year or early next.

MMI ended Monday trading at $38.12 a share, a price that I think signals two Wall Street’s beliefs:   that the acquisition is highly likely to occur, and that a rival bidder is probably not going to emerge.  That’s my take as well.

MMI has three main assets:  by far the largest is its massive collection of cellphone-related patents; it also has a set-top box business; and it makes handsets.

why the acquisition?

Look no farther than the competitive situation in the global smartphone market.

In the early stage of any market, the field is wide open.  Entrants focus on building their own market share and ignore everything else.  With smartphones, we’re long past this stage.

As the market matures, the competitive field separates into frontrunners, and also-rans.  Typically, the stronger entrants turn on the smaller, weaker competitors–who fall by the wayside, one by one.  Think NOK and RIMM as being on the losing end.

A further sign of maturity is when the top dogs–in this case, AAPL and GOOG–turn on one another as the only additional sources to fuel further growth.  This phase comes last because the market leaders are typically the most difficult and expensive to wrest customers from.

That last stage is where we are now.

According to ComScore, the Android operating system extended its market share lead in the US during the three months ending June 2011 by 5.4 percentage points from 34.7% to 40.1%.  During the same period, the iPhone added 1.1 percentage point of share, from 25.5% to 26.6%.  The overall situation:  APPL is losing ground to Android, picking up a decreasing share of the customers being shed by RIMM and MSFT (NOK has almost none left to take).

AAPL is fighting with patents

Several reasons for this:

–smartphones are by far AAPL’s largest business, so growth here is important,

–APPL doesn’t want to introduce lower-priced handsets to compete with GOOG’s mid-market offerings, and

–its lack of patents is a potentially severe point of weakness for GOOG.

last week’s EU tablet decision is a case in point

The details can be found in the blog Foss Patents, but the bottom line is that Samsung’s 10.1″ Galaxy Tab has been banned for now from sale in the EU, ex the Netherlands.  What’s interesting is that the design drawings on which the ruling are apparently based are very generic  (look at pp.3-4).  They look kind of like Etch-a-Sketch screens and boxes without the knobs.  In fact, a ZD Net article suggests that the iPad itself isn’t an original idea–it looks amazingly like the prop tablets actors used on Star Trek.

In any event, last week’s ruling suggests that patent litigation can be unpredictable.  It can also have potentially disastrous consequences for the loser.

better safe than sorry

$12.5 billion is about what GOOG generates in cash flow during one year.  It’s also a bit less than a third of the cash the company has on the balance sheet.  The fact that this money is earning very close to zero is a key reason why the acquisition of MMI will likely be “mildly accretive” to earnings from day one.

So the cash is not a real issue, particularly since control of the mobile user is so key to GOOG’s–and APPL’s–future.