Bermuda: LOM Weekly Perspectives

Continuing upbeat economic news in the United States has had a positive effect on equity markets. Growth stocks and cyclicals have benefited while defensives and staples have been hurt, though we have probably not seen the last of frequent sector rotation. The rally has sent bears running for cover as rising optimism has forced the hand of many professional investors. In such circumstances there is a real, or a perceived, opportunity cost of not participating in the market, which results in the commitment of new money to equities. An advancing market is important not only for generating an inflow of new money but also for keeping money already on the table. The rally in the fourth quarter, and the current upswing, have dashed bearish hopes of a significant correction. Investors have generally refused to take their money off the table. The run of wins in the late nineties was so good that they are willing to wait a little longer and see their fortunes turn. The performance of the equity market since last September has been good enough to raise hopes of further advances. It is difficult to tell how long they will wait and what sort of returns they hope will materialise before they decide to make major asset-class allocation decisions. Of course, reallocation decisions are not taken collectively, or suddenly - they will occur gradually. But it looks very much like there is still an expectation of the recurrence of double-digit returns for equities. If that is so, then some investors are in for an unpleasant surprise. In this context, the trap one should avoid at all cost is the gambler’s fallacy. When there has been a good run and then you hit a bad patch there is a tendency to think that the odds of another good run have increased. Unfortunately, this is not the case. You have to calculate new probabilities.

As we have said, many times before, the stock market in the U.S. is not cheap. If we use modified adjusted earnings then, in terms of the forward PE ratio or of the equity risk premium, a major index such as the S&P 500 is far from being a bargain. This means that on current valuations the total returns from equities, as represented by the S&P 500 index, are likely to be modest. We should hasten to add that investing in U.S. stocks will not necessarily lead to poor returns. Careful stock picking and a judicious equity portfolio strategy may be able to beat the market, but it will take a lot of luck or creativity to register a dramatically better performance. As for technology stocks, as represented by the Nasdaq index, there is still a lot of hope riding on them. Their fortunes are essentially tied to capital spending by corporations. Sadly, this year, business firms are not generating the sort of cash flows or encountering sufficiently tight constraints to significantly increase spending on hardware and software. Inevitably, in this environment, some investors are already exploring other avenues to place their funds: geographically, by asset class, and via different investment vehicles and asset management styles. That's a lot of ground to cover, and given the space limitations we can only examine one or two topics at a time. Let's start by looking at one possibility for geographical diversification.

The rapid rise in the Nikkei 225 reflects a seasonal event, familiar to the cognoscenti, supplemented by a good deal of government manipulation. So, it is a little too soon to assume that investment in Japan is back in style, although a number of large banks and brokerages have been making positive comments about it. Being long the Japanese market can be seen as a short-term tactical move. But it still doesn’t make a lot of sense strategically. There has been no significant government action on the structural and political fronts. One positive factor, though, is the sharp rise in Japan’s money base, which opens up the possibility of the deflationary trend being reversed. However, overall, we have had a lot of talk but little action from the authorities. Granted that when there is a turning point, the market is likely to move up substantially. The market as a whole is not particularly cheap, though cheaper than the United States. Nevertheless, the inflow of both foreign money and domestic retail money into equities could easily underpin a significant upswing. Currently, the best action on Japan is to monitor the situation closely with regard to signs of real change. In the past, entering the Japanese market precipitously has, too often, burned investors. Fearful of missing the boat, they have, soon enough, found themselves shipwrecked. The ones who did well were mainly those who employed careful short-term tactics of entry and exit. Shorting the market has also been popular with hedge funds, but the regulators are trying to put limits on that strategy.

The problem with Japan has always been that it is rich enough to tolerate the continuation of long-standing problems that have never really flared up into a full-fledged crisis. Also, as a creditor nation it has been able to ignore outside pressure to change – a luxury that has been available to few countries. The heavy costs of the status quo have been borne by the younger generation relative to the older, by urban dwellers relative to the countryside, by efficient industries relative to inefficient ones. The United States which used to consider Japan, as an economic threat no longer does so and views Japan as a close ally in the increasing geo-political rivalry with the ascendant power of China. How things have changed. Before the bubble burst in 1989 there were fears that Japan would become the dominant global economic power.