Last week, Japan's Nikkei 225 index enjoyed its longest winning streak in history which eventually ending after 16 consecutive days of gains, only to resume rising after a brief one day hiatus. And, as foreign investors once again flood the Japanese stock market, chasing the momentum which has pushed local stocks to levels not seen since 1996, the question on everyone's lips is how much longer can this continue?
Offering a decidedly downbeat outlook on Japan's market exuberance, Shannon McConaghy - portfolio manager at what we have in the past dubbed the world's most bearish hedge fund, Horseman Capital Management - believes that the euphoria is about to end. The reason: the ominously sounding "Iron Coffin Lid."
In a note released late last week, McConaghy writes that there has been a lot of excitement over Japanese equities of late, with hyperbole from the sell-side, and others interested in promoting Japanese equities, becoming extreme. However, he cautions that "there is not a lot of discussion around the risks to Japanese equities from current elevated levels" and adds that "one observation I would make is that Japan has risen to these levels on a number of occasions over the last 25 years, only to fail spectacularly each time against what is referred to, by some in the Japan markets, as the “Iron Coffin Lid”. History suggests it is far better to be short Japanese equities from these levels than to be long."
So what is this Iron Coffin, why does it have a lid, and what happens next?
Below is a visualization of this "Iron Coffin Lid" effect: it shows the key resistance level in the Topix beyond which the index has failed to progress every time in the past quarter century.
There's more than just a chart however: here is Horseman's take on why this latest rally in Japanese stocks is also set for disappointment.
For those unwilling to outright short, I would point out that historically Japan has had meaningful underperformance following past bursts of outperformance. In these periods it is particularly appealing to short against longs in higher growth areas. Japan also provides amplified short returns during global down turns. As such it can be a low cost but high return hedge to risk-off impacting long positions elsewhere. One way to identify when Japan is about to provide its greatest periods of underperformance is when its market capitalisation exceeds its Gross Domestic Product (GDP). Again, on this measure history suggests it is far better to get short Japanese equities at current levels than to get long.
One way to think about Japan’s persistent underperformance is that past market rallies have been quickly frustrated by structurally weaker GDP growth, as opposed to other markets with more sustainable growth. Japan’s GDP only grew +1.7% over the last 10 years, a CAGR of +0.169%. It grew even less in the 10 years prior. It is no mere coincidence that the market has failed to break out during decades of weak economic activity. Once again the market is pricing in significant economic expansion to come in Japan but its demographics, the key reason for past structural weakness, are only getting worse. I expect the euphoric hope held by many in the market, that “this time is different” in Japan, will once again be crushed by the “Iron Coffin Lid” that is Japan’s structurally weak economy. Long positions in Japan will likely be buried alive again while short opportunities thrive. Yes, Japan’s GDP growth rate has been higher since 2012, during what I would consider a recovery phase. But the drivers of growth in the three largest components of GDP growth are unsustainable, exhausted and now showing clear signs of reversing. Our market views to be released over coming days will look into these three major components of recent GDP growth in more detail.
Originating from Horseman Capital, hardly known for its optimistic outlook, here is the fund's take on why Japan is set for more pain once the current euphoria fades, and how to capitalize on this imminent decline:
As a short preview, Japan faces immense risks to its economic system from;
- Declining private consumption as the number of households in Japan starts to decline. Nowcast data also shows a marked decline in household consumption in recent months.
- A precipitous decline within the financial sector, an often forgotten component of GDP. With the Japan Financial Services Agency now reporting that most regional banks have become loss making in core businesses.
- A roll-over in the real estate sector as residential oversupply hits, vacancy rates rise, rents fall, prices decline in some areas and contract ratios indicate more price cuts are coming.
- Net export growth, which has been driven by a weak Yen and weak oil prices, faces a risk of the Yen strengthening 22% back to the long run real effective exchange rate, as well as continued oil price rises.
Short opportunities in regional banks, real estate developers, Real Estate Investment Trusts (REITs) and mid-size retailers are particularly appealing. The first three of these sectors, about which we have written over the last two years, have been noticeably weak but still offer significant downside. The retail sector, about which we have only recently began to write, has yet to turn down but was a notably weak performer in the last years of the last global credit cycle. Importantly we believe that shorting these sectors does not require an end to the global credit cycle, but they would likely generate amplified short returns in that environment and hence afford excellent hedges to other longs elsewhere.
Finally, it's worth recalling that as of one month ago, the BOJ already owned three quarters of all Japanese ETFs: a number which is now certainly higher, and is a non-trivial reason why Japan's stocks have enjoyed the recent surge. Of course, with ETF supply declining rapidly and the BOJ soon to be locked out of further purchases, the question is what will stoke further "flow" into risk assets (and frontrunning of central bank purchases), and will the BOJ expand its mandate further to buy single name stocks next in the name of "price stability?"