The U.S. Aging Crisis: A Threat to Stock Market Prices?
by Alexander Green, Investment U Chief Investment Strategist
Friday, March 9, 2012: Issue #1726

Robert Arnott claims that the U.S. aging crisis is a threat to future stock market prices. But do the numbers add up?

There’s a new scaremonger in town. And his name is Robert D. Arnott, a portfolio manager, asset-manager executive and Chairman of Research Affiliates in Newport Beach, California.

Mr. Arnott has a simple thesis. Over the next 10 years, the ratio of retirees to active workers will balloon. Retirees, of course, must eventually sell their stocks to support themselves. But there will be fewer young investors around to buy them. Ergo, returns on stocks over the next 10 to 20 years will be anemic.

If this sounds simplistic, congratulations. You probably have a brain and at least a modicum of common sense. This type of “stock market analysis” is really no analysis at all. More to the point, it doesn’t work. Just ask failed economic futurist Harry Dent, whom I’ve written about before.

While it’s inevitable that there will be 10 new senior citizens for each new working-age citizen over the next decade, that in itself doesn’t portend paltry equity returns.

For starters, let’s look at what’s happening to the world population as a whole. There are currently seven billion human beings living on the planet. At the current growth rate, that total is likely to hit eight billion within a decade.

Now, if you believe that investors in China, India, Brazil and other countries will have no interest in buying companies like Procter & Gamble (NYSE: PG), ExxonMobil (NYSE: XOM), or Coca-Cola (NYSE: KO) in the future, no matter how inexpensively they’re priced, I guess you might put some credence in Mr. Arnott’s thesis.

But that’s highly unlikely. Citizens of capitalist countries are getting wealthier and better educated all the time. And the world is becoming more integrated. Would you really have a problem buying shares of Toyota (NYSE: TM), British Petroleum (NYSE: BP) or Nestle (OTC: NSRGY.PK) if they were bargains?

Of course not, regardless of the demographic trends in Japan, Britain, or Switzerland.

Mr. Arnott doesn’t just miss the big picture about the future, however. He also misinterprets the past. In a recent Wall Street Journal interview, for example, he talks about the collapse of Japan’s stock market over the last 23 years and blames it on the country’s aging population.

I have a better explanation. When the Nikkei 225, Japan’s leading stock market benchmark, climbed to nearly 40,000 in 1989, it was a bubble of epic proportions. Many stocks traded at more than 100 times earnings. And real estate was even more absurd. Just the 1.32 square miles that encompassed the Imperial Palace in Tokyo were valued at more than all the real estate in California combined.

Now that’s nuts. Crazier still were the Japanese banks that loaned money against these wildly inflated property values. This led to a protracted banking crisis that Japan’s political class refused to clean up.

To imagine that the two deflationary decades that followed this mania were the result of an aging population is like blaming this year’s warm winter on your aching big toe. Yet Arnott insists we should hunker down since “[Japan’s] demography is 10 years ahead of ours.”

Want to know what will really determine stock prices in the future? Earnings. I challenge you to look back through history and find even one publicly traded company that increased its profits quarter after quarter, year after year, and the stock didn’t tag along.

Perhaps our aging retirees will buy less in the future and contribute less to U.S. corporate profits. But there are billions of consumers around the world hungering for homes, computers, cars, phones, health insurance, credit cards, pharmaceuticals and golf clubs. They’re likely to be an engine of world economic growth – and rising U.S. corporate profits – for decades to come.

Don’t let anyone scare you otherwise.

Good Investing,

Alexander Green

by Alexander Green, Investment U’s Chief Investment Strategist
Monday, April 25, 2011: Issue #1498

“Buy Japan now?” a friend asked recently. “Are you nuts?”

His sentiment is understandable. Aside from the unfathomable human suffering in Japan over the past several weeks, there have been enormous economic setbacks as well.

Sendai, the biggest port in northeast Japan and a major exporter of auto parts, machinery and marine products, was virtually wiped off the map. Half a dozen oil refineries in the same area, representing a third of the nation’s entire refining capacity, are shut down. Roads, bridges, railways and other major infrastructure have been destroyed. And the Japanese economy – already limping along for most of the past two decades – is also beset with the world’s highest public debt relative to GDP (225%) and a rapidly aging population.

Why would anyone want to invest here?

In my experience, those words accompany virtually every great buying situation. But it takes more than just a lack of interest to create a true contrarian opportunity. Both sentiment and valuations have to be at an extreme.

And that’s certainly the case here…

Japanese Stock Prices Are Less Than Book Value

The average Japanese stock is selling for less than 14 times its annual profit. That’s cheap, and Japanese accounting methods also tend to understate earnings. An even better indicator is found in book values (assets minus liabilities). Stocks around the world (including the United States, Europe and China) currently sell for approximately two times book value. In Japan, they sell for less than book value. By this measure, U.S. stocks are twice as expensive as Japanese stocks.

What will turn Japan’s market around? For starters, the enormous rebuilding that will be required over the next few years. Devastated areas account for seven percent of Japan’s economy and a substantial portion of its land mass. A lot of businesses will receive substantial contracts as a result of the catastrophe.

History shows that Japan is adept at rebounding from catastrophe. (Take World War II or the 1995 Kobe earthquake as examples.) And when Tokyo enters a bull market, it can look like the Silver Spurs Rodeo. For example, if you invested $10,000 in the S&P 500 in 1970, two decades later it would have been worth more than $76,000. Not bad.

But the same amount invested in the Nikkei 225 would have turned into more than $600,000.

How to Buy into Japan’s Advanced Economic Power

Although China’s economy has now eclipsed Japan’s in size, Japan is still Asia’s most advanced economic power, with world-leading technologies and an unmatched infrastructure.

The cost of doing business in Japan has decreased dramatically in recent years, as well. Land prices, office rents and labor costs have come way down. So have taxes and tariffs. And the government has instituted serious banking reforms.

The nation also sits on a mountain of personal financial assets – more than $100,000 for every man, woman and child. After a decade of negative stock market returns, most of this capital is sitting in low-yielding bank deposits. Even a small fraction of these assets returning to the equity market could give it a serious jolt.

So how do you play a rebound? Consider a Japan ETF or some of the country’s unloved blue chips like Toyota (NYSE: TM), Mitsubishi Financial (NYSE: MTU), Canon (NYSE: CAJ), or NTT DOCOMO (NYSE: DCM).

The healing there will take time, of course. But just as the U.S. stock market rebounded from the recent financial crisis quicker than almost anyone expected, things in Japan may look dramatically different in six to 12 months from now.

Of course, very few people believe that. But, in one sense, that’s a good thing. Negative sentiment and low valuations are the defining characteristics of contrarian investing.

Bottom fishermen, cast your nets.

Good investing,

Alexander Green

by Alexander Green, Chief Investment Strategist
Monday, June 28, 2010: Issue #1290

The Wall Street Journal reported last week that, for the first time in three years, foreign investors are increasing their holdings in the Japanese stock market.

Data released by the Tokyo Stock Exchange shows that foreign ownership of Japanese shares rose to 26% for the year that ended in March, up from 23.5% a year earlier.

The Journal suggests that a recovery in Japanese corporate earnings is tempting foreign investors back to the country’s equity markets.

But I think there’s more going on here. Perhaps hedge fund managers and other savvy global investors have paged back through their old, dog-eared copies of Dr. Jeremy Siegel’s Stocks for the Long Run.

If so, they may have recognized something significant…

Crunching the Numbers on Japan

Siegel notes that it’s rare for stocks to go 10 years without giving a positive return. Yet we’ve experienced just such a rarity over the last decade.

For stocks to go 20 years without giving a positive return is almost unheard of. And 30 years? That’s rarer than Big Foot, Nessie and the Abominable Snowman combined.

Which brings me back to Japan…

• In 1989, the Nikkei 225 – Japan’s equivalent of the S&P 500 – hit a new all-time high near 40,000. Today, more than 20 years later, it languishes near 10,000 – almost 75% lower.
• In other words, the Nikkei 225 would have to rise 300% just to get back where it was in 1989.

And it wouldn’t surprise me if it did just that by the end of the decade. After all, it’s happened before.

In the 1970s, the U.S. market returned just 0.34% a year – a 3.4% total return for the decade. Yet the Japanese market compounded at 16%, generating a 10-year return of 344%.

What other asset class offers that kind of potential return over the next decade? (Gold bugs, keep your seats.)

Don’t Chase the Bullet Train… Get on Board Now

The groundwork has been laid.

Last August, after more than 50 years, Japan’s opposition party trounced the Liberal Democratic Party in a landslide election.

The new government has promised to shrink the country’s massive bureaucracy and cut wasteful public spending. It also intends to end more than 20 years of economic stagnation by cutting taxes and focusing on small and mid-sized businesses.

Of course, we’re all skeptical of politicians’ promises, but there is evidence that they mean business this time. Twenty years is a long time to leave your economy in a funk.

It’s resulted in Japanese stocks being among the cheapest and most unloved in the world. Virtually no one is enthusiastic about the Tokyo market.

However, great opportunities are born when dirt-cheap valuations marry investor apathy. Plus, Japanese investors are flush with cash. They’ve largely ignored domestic stocks after two decades of sub-par returns. And as that money begins to find its way out of mattresses and back into Japanese equities, the Tokyo market should lift off.

This is doubly true when institutional money managers return to Japan in a serious way. For years, global fund managers have outperformed the world benchmark by simply underweighting Japan. But let the Shinkansen take off without them and they will be forced to dash after it.

So how do you play this?

Two Ways to Ride the Japanese Stock Market

There are dozens of worthwhile Japanese ADRs trading on Nasdaq and the Big Board.

But you can gain exposure to the Japanese stock market through two ETFs…

• iShares MSCI Japan Index (NYSE: EWJ), which invests in large-cap Japanese stocks.
• Wisdom Tree Japan Small-Cap Dividend Fund (NYSE: DFJ), which captures the best of the Japanese small-cap sector.

Or you can spread your bets and own both.

Incidentally, if you remain skeptical about Japanese stocks digging their way out of this 21-year hole, consider again how unlikely it is that Japanese stocks will earn a negative 30-year return.

As Dr. Siegel writes in Stocks For the Long Run:

“In the 12 years from 1948 to 1960, German stocks rose by over 30% per year in real terms. Indeed, from 1939, when the Germans began the war in Poland, through 1960, the real return on German stocks matched those in the United States and exceeded those in the U.K. Despite the total devastation that the war visited on Germany, the long-run investor made out as well in defeated Germany as in victorious Britain or the United States. The data powerfully attest to the resilience of stocks in the face of seemingly destructive political, social, and economic change.”

The story in Japan was similar. By the end of 1945, stock prices stood at about approximately one-third of their level just prior to the Empire’s surrender. Over the next 40 years, the Japanese market returned more than 20 times its American counterpart.

If 200 years of world stock market history is any guide, the current decade should be another barnburner for Japan.

Good investing,

Alexander Green