Guest Author: Jeffrey Dow Jones is a registered investment adviser with Jones & Company, a hedge fund manager. A longer bio available at a previous article.
This article is cross posted from The Draconian.
We’re going to get to Japan in just a minute. As usual, our perspective may sound a little different.
Market Recap
A couple weeks ago when all the economic data was rosy and before things got unsettled in far flung places, I wrote the following:
Separate the economy from the stock market. The economy may be all right and may sputter along with slow, but acceptable, growth. However, stocks are ultimately nothing more than a claim on a very long-term stream of future cash flows. And this is where the disconnect lies. Somewhere out there is a reckoning day. We all know this. We all feel this. What we are getting right now is on the surface a free lunch. We know deep down that there isn’t such a thing.
Reckoning days rarely work themselves out directly. That is to say: people don’t wake up one day, realize that there’s a problem and then immediately pay a price. It’s typically something else that indirectly triggers a correction of the original problem.
The series of disasters in Japan are a good example of that, as was the spike in crude oil on the Middle East revolutions before it. In the grand scheme of things these events have very, very little to do with the long-term performance of U.S. stocks. But what happens is these events trigger caution and fear amongst investors which then acts as a catalyst to send the markets towards where they need to go.
As of yesterday, stocks were down for the year and after this morning’s relief rally, they’re pretty much flat:
Things change quick in the market, huh? As usual, the 50-day moving average offered a nice helping hand if you were late in getting out. If you’re still heavily long, I’m not sure what sort of advice I can give you.
Sometimes we take a little flack for being so generally cautious and for spending so much time on risk management strategies. Weeks like this are why. One of the most important principles of portfolio management is to get your risk policy implemented before the disaster strikes. The time to find the emergency exits is before the movie starts not after the theater has caught fire.
If you’ve constructed the right kind of portfolio with the right kind of risk controls then it frees you up to be able to take advantage of opportunities in the marketplace.
And that’s what we’re going to talk about now.
Drafting for value
Earlier this week we had our fantasy baseball draft (click here if you want to spy on my team). I play in a few leagues but this is my favorite. My fellow Draconian co-workers are in it, and so are a couple buddies and my roommate from college. True to my word from a couple weeks ago I wound up drafting a lot of the players that everybody seems to hate this year. I didn’t just grab every ugly duckling that was out of favor; I did my research. Remember: some guys are out of favor for a reason.
I tried to sort out the guys that were ranked too low for no legitimate reason. Luck plays a big role in baseball and most of these out-of-favor guys had an unlucky season last year. It pays to understand this because fantasy baseball people suffer from the same recency bias that investors do. They overweight the importance of recent data and ignore much of the data that came before it.
When it comes to fantasy baseball, the guys that get drafted higher are usually the ones who had really good seasons the year immediately prior. Investors do the same thing and sit down every January to re-balance their mutual fund portfolio, flocking to the funds that performed best in the previous year. Performance chasing is one of the worst sins you can commit as an investor. The way you win your fantasy baseball league is by being good at identifying the guys that will do well this year, not last.
I grabbed the following screenshot from my bank the other day. These brokerage aren’t morons and they know how the investing public shops for funds:
Anyway, our baseball draft inspired me to take a look around the world and find some investments that are really out of favor right now. I’ll offer three of them and deal with them in order of increasing risk.
Real Estate
Real Estate is the obvious one. I’ve written about that enough in the last couple of months. You all know where we stand on that. It’ll be a slow grind for a year or two as we sort out the massive oversupply but at some point the market will normalize. There’s still plenty of distressed listings out there. For the first time in a long time investment properties finally pencil. If you need a place to live — finally! — it’s cheaper to own.
Just like fantasy baseball, everybody is down on real estate right now because it had a disastrous couple of seasons. One of the players I drafted this year cost $20 at last year’s draft. He had spent six years as one of the top guys at his position. He was money in the bank! But last year he had some ridiculously bad luck and then got a fluke concussion and sat out the rest of the year. It was a disaster for everybody who owned him. He may not be the top outfielder once was, but this year I paid $5 for him. He should return at least double that. Placing too much emphasis on how he did last year is wrong.
Look, the real estate bubble wasn’t a fluke. I knew something was up when I got my first mortgage back in 2004. We knew that something was going to happen because we knew there was a bubble and that’s just the way that things go in the wake of a “POP”.
But the point is that’s over now. And everybody has forgotten about all the history that came before the housing bubble. There was a time — say, the mid 90′s — where people bought a house and didn’t worry about whether the price was going to go up or down. That’s the historical norm for the housing market. For all intents and purposes, we are at or are close enough to that point where most people can sleep OK at night if they choose to enter the market.
It should go without saying but I’ll say it anyway: don’t be stupid about it. I watch the local listings. A lot of properties around town are priced correctly. But many are not and you can tell because they’re the ones that have been sitting on the MLS for 347 days. Don’t buy these. These people are still living fantasy land. Don’t get all emotional about buying a house and don’t indulge these yo-yos. Prices are still falling, but a lot of it is just non-distressed properties catching up with the rest of the market.
Japan
This is what I’ve got my eye on right now. Obviously our thoughts and prayers are with the millions affected over there. It’s a sensitive issue right now but this is something that investors really need to start looking at. Don’t jump in head first, but start looking.
In the aftermath of the global financial meltdown we have become a society that benchmarks things as “the worst X since Y.” In Japan they’re calling this the worst crisis since WWII. (It’s true, unfortunately, but if you want to argue that their “lost decade” was a crisis I’ll listen.) But their markets are going to be a little chaotic for a while and the news flow will be negative.
There are still millions without power. Shibuya has been totally dark to conserve energy. The big story is the, uh, “difficulty” they are having with some of their nuclear reactors. 20% of their electricity comes from nuclear and believe it or not it’s about more than just the risk of meltdown.
I saw one of my friends on Facebook got the whole week off of work and immediately after that they said on Bloomberg that lots of people wouldn’t be going to work for a while. Make no mistake; all that is going to have a major economic impact. This is undoubtedly going to slow down their economy for the short term.
But we’re trying to bring the big picture into focus and the history you need to understand is that investors have hated Japan for decades.
In a sense, Japan is a lot like a slow-motion version of the U.S. housing bubble. There was unprecedented historical excess and then a long sluggish period that followed as the problems were getting fixed. I was at a hedge fund symposium a couple years back and somebody asked one of the panelists about Japan. The guy laughed and said, “the funny thing about Japan is that people keep trying to make it interesting, and fundamentally, it’s just not.” For years investors have been wondering where the bottom is in Japan. I wish I knew the answer to that question.
But I do know this. This is a country that recovered from the almost-unimaginable catastrophe of the war to become the second largest economy in the world. It is a tremendous society and they deal with pain better than perhaps any culture in the world. The Japanese have always been known for great inner strength and calm, rational wisdom. Those characteristics will be their greatest asset as they recover from this disaster. They will reinvent themselves and rebuild.
Will this be final straw? If this is indeed the worst crisis since WWII one needs to ask if this is the final catalyst that their economy has needed to get it back on something resembling a growth track. Obviously, the details are still a ways from being known, but a whole lot of rebuilding is going to need to happen in Japan in the coming years.
The problem, of course, is the one that existed prior to the earthquake. It’s their nightmarish demographics. Japan has an old and rapidly aging population. They have one of the lowest fertility rates in the world. The other side of the resilient Japanese culture is that their island-society is rather xenophobic. There is virtually no immigration into the country.
You might not pay much attention to demographics when constructing your top-down investment view, but you should. Over the long-run, demographics and geopolitics are two of the most powerful — and easy to predict – variables in a country’s growth equation. Japan’s demographic problems basically put a cap on how much the country can grow its GDP. It places a lot of pressure on young kids coming into the labor market because they have to support the top-heavy population. Fewer workers and fewer citizens means fewer people contributing to the economic growth pie. The good news is that nobody should have trouble getting a job in Japan for at least an entire generation. Especially after this earthquake.
The other bit of good news is that their economy is export dependent. They run trade surpluses with pretty much every country in the world, even China! Japan makes stuff that the rest of the world wants. And the rest of the world is doing OK right now.
Don’t just go all in and buy Japan. As with real estate and fantasy baseball, be selective and do your research. When shopping for companies to buy, buy the ones that derive most of their growth from abroad. The Japanese economy may have something of a growth cap on it but that’s not to say that every company in Japan will have limited growth. It will be asynchronus.
Avoid the companies that are focused on internal demand and internal consumption. Why buy a Japanese utility company when you can buy an American utility? Or even better, a Chinese utility? Stay away from their zombie banks too. This earthquake is going to eviscerate small business over there and that’s bad news for the banks that have loaned these businesses money.
The other catch is their currency. Japan is saddled with almost unimaginable levels of debt. Think that our debt load is bad? Try doubling that. And this earthquake won’t help the situation either.
While this crisis could be a catalyst to get Japan’s long-term economy back on track, this could also be the end of the line for the strong Yen. I know that a lot of people out there have been trying to short the Yen for years. That road is littered with the bodies of blowed-up hedge fund managers, forex desk chiefs, and amateur currency mavens. Is it finally time to short the Yen? Yes, here at the highest levels since WWII, it might finally be time to strap in short the Yen.
If you’re going to get serious about investing Japan, think long and hard about some sort of currency hedge.
Nuclear power
Nuclear power was hot stuff before the earthquake. I even wrote a fairly detailed piece on some investing strategies for it. Up until a week ago that had been a pretty tremendous investment. Obviously, what’s happening at the Fukushima-Daiichi site has changed the game.
There’s a lot of concern right now that this may change the policy direction for nuclear energy. So far the global reaction has been mixed. Germany has put up some new roadblocks but they were a country that didn’t like nuclear power to begin with. France, which gets 90% of its electricity from nuclear sources has been very vocal about helping Japan get this reactor issue cleaned up, like, rapide. Obama made nuclear energy a big part of his campaign and so far the administration’s line has been that they still endorse it. I heard the other day he called for $36 billion of loan guarantees to help fund the construction of new reactors. China, as you probably could have guessed, said, “whatever” and is going full steam ahead to roll out all their new nuclear plants.
This is a fairly critical juncture for the future of nuclear energy. If this winds up more like Three Mile Island where nobody gets hurt and no serious environmental damage persists, then there’s a future. It won’t be the future that would have been, but at least there will be some future for nuclear power. If this winds up like Chernobyl (or worse) there may not be a future.
As we all sit around and ponder this and hope that they can get this fuel core cooled down without much additional radiation leakage, keep a few other things in mind. Last year we had the worst coal disaster in this country in 40 years — far more people have been killed in coal mines than nuclear plants. Last year we also one of the worst oil spills in history. Remember how pissed everybody was at BP? The endless stream of photos of pelicans soaked in oil and black beaches? Remember the offshore drilling moratorium?! There was even some honest debate about whether this was a policy our nation wanted to continue. Kevin Costner got involved! But eventually everybody just said “meh” and went back to filling up their gas tanks. We’re all watching what’s happening in the Middle East right now and glad we didn’t shut down a bunch of our own wells.
And, BP came back:
None of this is to imply that this industry is going bounce right back. Policy makers are super slow to react. They’ll chew on this and debate this for a while and so it will remain uncertain while we weight pros and cons. And maybe that’s OK as public backlash slowly recedes. It’s not a bad strategy. I give these politicians a hard time, but they’re clever folk and when it comes down to it they’re basically just survivalists.
And as a final thing to consider in a fact-based debate about whether or not the world should consider continuing to pursue nuclear power:
The reactor at the Fukushima-Daiichi site is one of the oldest reactors in the world. This 40-year old plant has, for the most part, survived one of the worst earthquakes in history followed up by a gigantic tsunami. If this creaky old reactor can endure a natural disaster of this magnitude, what about the ones that are being designed and built nowadays? What about the ones that are being built in places that don’t have earthquakes and tsunamis?
The strategy for global energy production is one that will play out over the next century and not the next few weeks. All of this may be moot for a few years because coal and natural gas power plants are still cheaper than nuclear to build and operate. But a lot of people are writing this sector off completely and that might be a little hasty, especially when most of the equity damage has already been done. There is still tremendous risk present here and there is no guarantee the debate about this will remain rational.
As always, practice caution and keep a long term perspective.
- Investing in the things that everybody else hates can be a great strategy if you’ve got the stomach for it and know how to separate fact from fiction and emotion from logic.
- Real Estate, Japan, and now nuclear energy are three places that the world hates very much right now as an investment. Risks abound, but there are opportunities in each for those that know how to do quality due diligence.
- The market is now basically flat for 2011. Weeks like this are why we’ve been so cautious lately and are keeping so much dry powder on hand. Stay tuned and we’ll let you know when there are short-term opportunities to deploy some of that. In the coming weeks we’ll outline strategies for scaling back into the market.
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