Monday, July 22nd, 2013

The Game’s Afoot

Sherlock Holmes would have been a great fund manager. There are numerous quotes which demonstrate his mastery of data analysis, but some of the most interesting are concerned with what not to analyse. “There comes a time when for every addition of knowledge you forget something that you knew before. It is of the highest importance, therefore, not to have useless facts elbowing out the useful ones.”

For most of the last 20 years, many investors would have included information about Japanese equities under the category of useless facts. That view changed at the end of 2012. Now that the LDP and its coalition partners look to have won a super-majority in the upper house, these same investors are scrambling to re-acquire the knowledge they had in the 1980’s.

There is no consensus as to which sectors will benefit most from the programme of supply-side reforms due to be unveiled in September. This is partly because very little detail is available yet, and partly because the market is still dealing with the impact of the cheap yen and abundant liquidity, which are the other two arrows in Abenomics. We make no claim to expertise on Japan, but we are happy to apply the same process that we use in other equity markets. So, here are the main conclusions from Harlyn’s sector rotation model for Japan, which has outperformed the index by 10 percentage points over the last 12 months.

At the top of the leader board are Consumer Discretionary (led by the car-makers) and Financials, the two most obvious beneficiaries of the first two arrows. They are followed by Telecom and Utilities, which started to perform well in March, long before the sell-off of the index in late May. Fifth and sixth are Materials (which in the case of Japan is mainly Chemicals, not Mining as it is in the UK) and Industrials – both sectors which may in the long run benefit from a weaker yen. Technology and Consumer Staples are next, with Healthcare and Energy at the bottom of the table.

Several things are odd about this ranking. Everywhere else in the world our models rank the defensive sectors in precisely the reverse order: Healthcare first, then Consumer Staples, then Utilities and Telecom at the bottom. Elsewhere, Industrials and Consumer Discretionary are usually next to each other in the ranking, but in Japan there is a gap of five places. Energy and Materials are likewise close together in most other regions, but in Japan the gap is five places (again).

We draw three general conclusions: (1) Japan is different. It was different on the way down; it will be different on the way up. Deductions based on US or European experience are likely to be wrong. (2) After years of disappointment, Japanese equities are illiquid. By the time details of the supply-side reforms have been published, prices will have moved. Fundamental analysis will be used to rationalise past performance, not predict future performance. (3) Information about Japanese equities only ceases to be useless if investors believe there is a second leg to this rally. If that is the case, the most important point is to buy the index now, and worry about sector rotation later.

In the words of the great man: “You know my methods, Watson. Apply them.”

Our sectoral presentation pack for Japan, with more detail on the above observations, may be viewed on our Equity Sector Models page. It also features our sectoral observations on the US, UK, Eurozone and Pan-Europe, all updated weekly. You will need to register and log in to view this page. However, given its topicality, we are making available a PDF copy of this week’s Japanese sectoral presentation to all – just click on the link.

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