-->Buying Tokyo
The Daily Reckoning
Paris, France
Thursday, 14 August 2003
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*** Greed or Fear? Depends when you're looking...
*** Bonds crumble... Freddie and Fannie wobble...
*** Between Iraq and a hard place... and more!
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There are only two major emotions on Wall Street - greed
and fear. Events are meaningless in themselves. Even the
murder of an Archduke or the burning of the Reichstag might
have had happy endings, for all we know.
From a short-term investment standpoint, it is not the
event itself that is important... but how it is spun in
investors' minds. At market bottoms, everyone is fearful
and almost every event is considered an omen of doom. At
tops, on the other hand, it is hard to find an event that
doesn't spin happily in their thick skulls, like a top in a
vacuum. In Tokyo, at the height of the late '80s bubble,
even an earthquake caused investors to celebrate; and in
America following the destruction of the Twin Towers,
commentators such as Larry Kudlow explained how this would
cause a war... which would be good for the economy and the
stock market!
And now we have the bond market collapsing.
What does it mean?
We don't know, but almost all economists, analysts and TV
newsheads are treating it as good news, as if it were
equivalent to finding a liquor store that made home
deliveries on Sunday.
We have a few essential insights here at the Daily
Reckoning: busts follow booms... you can't get something for
nothing... and even the rosiest dawn of greed sooner or
later gives way to a cold midnight of fear.
Our mission here is to squint and try to see things, not as
others see them now, but as others might see them after the
lights go out. Investors think rising bond yields reveal a
pick-up in the demand for money - a sign that the economy
is beginning to heat up.
But with our eyes wide shut, we think we see the outlines
of something else: lenders are getting worried; they are
asking for a higher return to cover the increased risk.
And if they aren't, they should be.
The U.S. has been the biggest beneficiary of the Dollar
Standard system; soon, Americans will be its biggest
victims. The Dollar Standard monetary regime allowed
Americans to buy things they couldn't afford... and then not
have to pay for them. Instead, they just gave out
'dollars.'
Now, you can hardly turn over a rock or look under a seat
cushion anywhere in the world without finding a U.S. dollar
bill or dollar bond. And they're increasing at the rate of
about $1 million per minute. That's the most recent measure
of the U.S. current account deficit.
The world has never seen anything like it. But as night
follows day, we know it will come to a bad end. But, unlike
night following day, darned if we know when.
"How much longer will the rest of the world be willing to
accept debt instruments from the United States in exchange
for real goods and services?" asks Richard Duncan in his
book, The Dollar Crisis."It is only a matter of time
before the United States will no longer be considered
creditworthy. In fact, it really is only a matter of time
before the United States will NOT BE creditworthy."
Mr. Duncan has the right idea. But his book may need an
update. The U.S. is already not creditworthy... for there is
no way it can pay off all of its debts and obligations with
dollars of today's value. The moment when investors will
realize this, however, still lies somewhere in the dark
night ahead.
We don't know when the sun will finally set on the dollar
and the Dollar Standard monetary system. But we think we
hear the bell for vespers. Dollar holders... and bond
investors... may want to say a silent prayer.
And now over to Eric Fry, our man in California...
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Eric Fry, checking in from San Francisco...
- Your New York correspondent - filing his report today
from the left coast - arrived in San Francisco earlier this
week to participate in the Agora Wealth Symposium.
Yesterday afternoon, he strolled around the City by the Bay
like a tourist, even though, in a former life, he lived and
worked in San Francisco for eight years.
- The brilliant sunshine accentuated many visible legacies
of the Internet boom years: immaculate new sidewalks, a
palm-tree-lined Embarcadero, shiny refurbished trolley cars
and innumerable 2-year old Infinitis and BMWs zipping up
and down California Street.
- But this near-flawless, picture-postcard city was eerily
quiet... its spotless sideways conspicuously underutilized.
"Where are all the people?" your New York correspondent
wondered to himself."It was never this deserted when I
lived here in the mid-to-late 1990s."
- Even the crowds of tourists - although certainly not the
tourists themselves - seemed noticeably thinner than they
used to be. The formerly standing-room-only cable cars
offered plenty of sitting room. From a tourist's
perspective, there's probably never been a better time to
visit this delightful city. But what's making this city
hum? Who's doing the work required to make the money
required to pay the taxes required to shrink California's
gaping budget shortfall to something less than $40 billion?
- To be sure, one tourist's observations are not conclusive
proof of economic difficulty. Maybe San Francisco is doing
just fine economically. Maybe the city's high-tech
inhabitants shun the sunlight like albinos, and huddle all
day in front of their PC monitors, generating income in
some kind of reclusive, high-techy sort of way.
- Ah well, the stock market bubble was fun while it
lasted... but it is definitely over, no matter how hard
Greenspan tries to resurrect it. In other words, the
bursting of the stock market bubble is history. Meanwhile,
the bursting of the bond market bubble is history-in-the-
making.
- Bond prices crumbled again yesterday, causing long-dated
Treasury yields to soar to fresh one-year highs. The 10-
year Treasury note tumbled 1 6/32, pushing its yield up to
4.58%. The staggering bond market crippled the stock
market as well, as the Dow Jones Industrial Average dropped
38 points to 9,271.76, ending a five-day winning streak.
The Nasdaq dipped half a point to 1,687.
- The bond market remains THE story of the U.S. financial
markets... which means that the mortgage-lending sector is
at least A story of the U.S. financial markets. As interest
rates soar, mortgage activity is evaporating. Mortgage loan
applications dropped another 16.1% in the week ended Aug.
8, and are down about a third from the peak levels reached
in May. If yields continue their meteoric ascent, the
mortgage market will flame out like a supernova.
- Mortgage giants Fannie Mae and Freddie Mac may be flaming
out already. Now that the 10-year Treasury yield sits a
whopping 147 basis points above the yield of 3.09% it
touched on June 13th, what good could possibly befall a
mortgage lender, especially a highly leveraged, thinly
capitalized, ultra-aggressive mortgage lender like Fannie
Mae or Freddie Mac?
- Your New York editor has no personal axe to grind against
either mortgage lender (although a member of his family is
short one of the stocks), but as a seasoned observer of the
financial markets... he suspects that the shares of these
two financial giants are, best case, two of the most
dangerous 'longs' in the U.S. financial markets.
- According to the New York Times, Fannie's own 'What if?'
scenarios from a few months back predicted that the
company's portfolio would suffer a $7.5 billion loss"if
interest rates rose immediately by 1.5 percentage points."
Guess what? 10-year Treasury rates have jumped 1.47
percentage points in less than two months. Does this mean
that Fannie is nursing some multi-billion portfolio losses?
Investors should not be surprised if this were true.
- What's more, according to the Prudent Bear's Doug Noland,
Fannie Mae's balance sheet is ill-prepared for adversity.
"Fannie Mae ended June 30, 2000 with a Total Book of
Business (mortgages held in its retained portfolio and
mortgage-backed securities it has guaranteed) of $1.247
trillion," Noland calculates."The company had an
Allowance for Losses of $808.9 million, or 0.06% (six basis
points) of its Total Book of Business... Over this period,
the company has gone from $1 of loss reserve for every
$1,541 of business exposure to $1 for every $2,537 of
exposure... It will take some time, but the thinly-
capitalized and fatly risk-exposed GSEs have (with the
Fed's assistance) placed themselves in serious harm's way.
I see no way for these institutions to now sidestep
eventual collapse, unless speculative market dynamics are
somehow repealed."
- Imagine a parent who stores crates of explosives under
his baby's crib and you will understand something about
Fannie Mae's approximate financial profile. Now imagine
that the parents slide the baby's crib and explosives over
next to the radiator (in order to make room for more
explosives) and you will understand something about Fannie
Mae's corporate philosophy: 'But why worry; the explosives
are unlikely to detonate.'
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Bill Bonner, back in Paris...
***"I thought it was a good idea," said the woman on your
editor's right at last night's dinner."But I'm not sure
what happens now. It's beginning to sound like Algeria. And
that didn't end very well for us."
"I remember well my meeting with a French member of the
Foreign Legion on the island of Corsica in the 1960s,"
writes Marc Faber in his most recent issue of the Gloom,
Boom and Doom Report."He had fought in 1954 at Dien Bien
Phu in Vietnam, and served during the Algerian uprising
prior to Algeria gaining independence in 1962. According to
him, his regiment was relieved when they left Vietnam.
Every legionnaire was looking forward to being stationed in
Algeria, which they though would be like a paradise when
compared to the tough campaign and eventual hellish defeat
they had experienced in Vietnam.
"However, this proved to be an illusion. According to him,
the Algerian war turned out to be far worse than Vietnam,
because the French troops in Algeria never knew who was
friend or enemy and therefore incurred tremendous
casualties in continuously recurring ambushes, acts of
sabotage, and raids on their camps. The problem with
guerilla wars is that the enemy isn't visible, and so,
unless the local population almost unconditionally supports
the occupying forces, guerrillas can easily hide among and
seek support from the local population.
"Claus von Clausewitz describes in his classic work On War
(first published in 1832) that any 'attack which does not
lead to peace must necessarily end up as a defense. It is
thus the defense itself that weakens the attack. Far from
this being idle sophistry, we consider it to the greatest
disadvantage of the attack that one is eventually left in a
most awkward defensive position'."
***"Has the Japanese economy finally bounced after falling
for 13 years?" we wondered yesterday.
"If we were placing our bets," we concluded,"we would much
rather bet on a market that has been deflated out than one
that is bubbled out to the limit of its inflationary stage.
Sell New York. Buy Tokyo."
No sooner had the words escaped our mouth than heads began
to nod in agreement.
"There is a strong case to be made that Japanese shares are
greatly undervalued," writes Alexander Green, editor of the
Oxford Club."By many measures, Japanese stocks are among
the cheapest in the world today.
"For that reason, I'm recommending a conservative way to
capitalize on a rebound in Tokyo: buy the whole market..."
More from Mr. Green on 'buying Tokyo,' below...
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The Daily Reckoning PRESENTS: A prime investment
opportunity in... Japan?"For contrarian investors," argues
the Oxford Club's Alexander Green,"now - when abject
pessimism about the country's future is at its zenith - may
actually be an historic buying opportunity..."
BUYING TOKYO
By C. Alexander Green
Japan is 14 years into an economic crisis. In fact, the
world's second-largest economy has been stagnant for so
long it has essentially abdicated its once-leading role in
Asia and the global economy.
There are several reasons for this. The country experienced
a huge bubble in its stock market in the late 1980's. (In
fact, this bubble bore more than a passing resemblance to
the technology stock mania of the late 1990's.) In 1989,
Japan's index - the Nikkei 225 - soared to 39,000 and more
than 100 times earnings. It was accompanied by an equally
magnificent real estate bubble.
Unfortunately, Japanese banks were busy lending money
against these pie-in-the-sky real estate values. More than
a decade later, property prices in Japan have fallen over
80%, devastating the Japanese banking system.
In the early 1990's, the U.S. had its own massive problem
in the savings and loan industry. The Resolution Trust
Corporation was formed to clean house. And it did.
Nothing like this has happened yet in Japan. So far, the
country's inept political system has refused to address the
problem. As a result, the Japanese economy stumbles along,
zombie-like, while its bankrupt banking system continues to
lend money to technically insolvent companies.
Politicians in Japan have made the situation even worse.
Rather than cutting taxes sharply to stimulate the economy
early on, the government enacted huge spending programs to
stem the economic decline. This involved massive public
works projects, including highways that weren't needed and
bridges to nowhere. In short, Japanese taxpayers saw more
pork than the average butcher at Oscar Meyer.
Needless to say, it didn't work. The dysfunctional banking
system and the huge budget deficits resulted in a
relentless deflation that has been eroding prices in Japan
for over a decade. As a result, consumers - ever fearful
that things will get even cheaper - refuse to spend. And
that has caused the deflationary cycle to grow ever more
vicious.
In fact, things have gotten so bad that last year Moody's
took the unprecedented step of downgrading Japan's credit
rating from A1 to A2. That's lower that Botswana's.
All in all, over the past decade and a half, Japan has seen
the bursting of an investment bubble... a sickening
deflationary crisis... a market index that has plummeted
82%... and the emergence of a very black mood among
consumers and investors. Yet for contrarian investors, now
- when abject pessimism about the country's future is at
its zenith - may actually be an historic buying
opportunity.
There is a strong case to be made that Japanese shares are
greatly undervalued. For starters, the Japanese government
is finally getting serious about banking reform. It's true
the ruling Liberal Democratic party continues to try to
foil the initiatives of the Koizumi government. But as the
crisis has escalated, intense pressure to make meaningful
changes to the banking system keeps growing.
Secondly, real estate prices have now fallen much further
than rents. Many Japanese properties now yield more than
10% annually. That provides support for real estate at
these levels and indicates a bottom is at hand. With
returns this high, it's unlikely Japanese property values
will fall dramatically from here.
Another positive sign is that Japanese profits are already
on the upswing. According to Morgan Stanley, profits for
listed companies in Tokyo (excluding banks and other
financial concerns) rose 80% in the fiscal year that ended
in March.
Yet by many measures, Japanese stocks are among the
cheapest in the world today. An amazing 60% of Japanese
listed companies have a market capitalization that is lower
than the value of their net assets. (U.S. companies in the
S&P 500, by comparison, sell for more than five times this
much.)
More importantly, every bit of bad news detailed above is
already reflected in Japanese share prices. No one is going
to sell Japanese stocks today based on the gloomy news of
the past decade. But a glimmer of positive news - like
genuine banking reform - would drive Japanese share prices
substantially higher.
And that may happen soon. The Japanese people have socked
away more than $250 billion in cash. Unfortunately for
these thrifty folks, Japanese government bonds pay only a
smidgen more than nothing. (Mortgages of less than 1% are
commonplace.) When the stock market begins to gather steam,
huge sums of cash are likely to leap from the sidelines,
adding fuel to the fire.
As chief economist Stephen Roach of Morgan Stanley put it,
"the Japanese consumer may represent the greatest source of
pent-up demand for a major economy in the modern era."
Finally, it's important to note that global money managers
have managed to beat the international index over the past
decade just by severely underweighting their exposure to
Japan. If the Japanese market starts to take off, they will
be forced to invest billions to keep from underperforming
their benchmark.
And let's not forget that Japanese stocks provide a
wonderful dollar hedge. If the dollar falls 20% against the
yen, for instance, Japanese shares will be worth 20% more
in dollar-terms, even if the Japanese stock market goes
nowhere.
There is risk in this scenario. By backing away from
meaningful banking reform, the Japanese political
leadership may end up winning the Rubber Backbone Award. Or
some other yet-unknown screw may come loose.
For that reason, I'm recommending a conservative way to
capitalize on a rebound in Tokyo: buy the whole market.
Just as you can buy an index fund based on the Dow, the S&P
500 or the Russell 2000, so too can you buy a publicly
traded index fund that replicates the performance of the
Japanese market. It's called the MSCI Japan Index Fund
(AMEX: EWJ).
This is the most heavily traded international index in the
U.S. And it has plenty of liquidity, with more than $1
billion in assets. It's made up of many companies you
already know and patronize. For instance, the top ten
holdings - which make up over a quarter of the fund -
include Toyota, NTT DoCoMo, Canon, Sony, Honda and Nissan,
among other well-known international brands.
Buying the Japanese market today is contrarian investment
at its boldest. But as investment legend John Templeton has
often said,"the greatest bargains can only be found at the
point of maximum pessimism."
Sell New York. Buy Tokyo.
Regards,
C. Alexander Green,
for the Daily Reckoning
P.S. True, there is risk investing in Japan. But the
potential upside more than justifies it.
Japan's economic woes are well-publicized worldwide. So the
average investor - to the extent that he considers the
Japanese market at all - thinks investing in this part of
the world is absurd. And that, of course, is why it's such
a splendid contrarian investment opportunity.
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