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Craig Allen: Japan’s Recent Plunge Should Give U.S. Investors Pause

Japan’s Nikkei Index dove more than 7.3 percent last Thursday on a combination of a stronger yen, weak data from China and, most notably, concerns over the timing of the tapering off of QE3 here in the United States.

With the Dow Jones Industrial Average up 16.7 percent this year, a similar drop could erase nearly half of the year’s entire gains in a single trading session. And with U.S. markets superheated, investors should take note of Japan’s dramatic slide (the Nikkei was down another 3 percent when Japan’s market opened Monday morning) and be prepared for a possible similar shock here at home.

There are striking similarities between the economic stimulus policies in Japan and the United States. The centerpiece of “Abenomics” — the fiscal policy of new Prime Minister Shinzo Abe — has been, and continues to be, the implementation of quantitative easing on a scale approaching that of the Bank of England and the Federal Reserve.

For most of 2012, Japan was caught in recession, its third bout of economic weakness since the beginning of the financial crisis in 2008. During the final quarter of last year, however, growth returned, with Japan expanding by 0.3 percent before the recovery accelerated into the first quarter of this year, with annualized growth of 0.9 percent.

Japanese industry has been leading the charge. Manufacturing, which still accounts for a fifth of all output, surged by 2.2 percent during the first quarter, a stunning reversal from its 1.8 percent contraction the quarter before.

Japan’s stock market performance, which has been led by its manufacturing sector, has been driven partially by the falling value of the yen. On a trade-weighted basis, the currency has lost 10 percent of its value so far in 2013, as the Bank of Japan has undertaken a massive injection of yen into the economy. These massive domestic liquidity injections have flowed directly into Japanese stocks, with an avalanche of international short-term investment assets following close behind.

In the United States, the Fed’s quantitative easing (QE3 — the third round of enormous cash injections into our economy) is pumping $85 billion each month into long-term bond purchases. With about eight months of QE3 in the books, the Fed has already purchased almost $700 billion of long-term bonds, driving long-term interest rates to historic lows.

The problem, as with Japan, is that all of this stimulus to-date has not resulted in any significant improvement in either the U.S. or Japanese economies. What it has resulted in, in both countries, is huge increases in equity values, pushing stock valuations to overbought, unsustainable levels. Thursday’s shock in Japanese stocks underscores the significant risk inherent in both the U.S. and Japanese stock markets.

Surprisingly, U.S. stock markets shrugged off Japan’s woes in Thursday trading, losing a paltry 80 points on the day. Japan rebounded slightly — by about 0.9 percent — on Friday, demonstrating little resilience, especially given the white-hot buying frenzy experienced thus far, year-to-date. Early indications from Japan show continued weakness, with the Nikkei losing another 3 percent-plus in early trading.

Most market watchers believe Thursday’s sell-off in Japan was mostly due to concerns over the Fed’s future plans for QE, rather than the strengthening yen or China’s slowing economic activity. The eyes of the world, and especially investors across the globe, will be on the Fed’s meeting minutes from the two upcoming sessions — June 18-19 and July 30-31, along with the speeches Fed Chairman Ben Bernanke and company will make, all leading up to the September meeting.

Most Fed watchers believe the Fed will begin to taper off its QE activities by Labor Day on Sept. 2. Some have suggested, however, and some Fed governors have indicated, that QE could begin to slow as soon as next month. The uncertainty surrounding the impending end to QE and the eventual end to this stimulus is certain to cause even more volatility in markets across the world, even here at home where stock markets have thus far not seemed to care much.

Sensing the risk to U.S. stock markets, Bernanke has recently stated that the Fed will be “flexible” with regard to any changes in QE, and although it must begin to taper off sometime soon, the Fed will ramp it back up if needed. It is unclear whether this statement of the Fed’s ability and willingness to undertake more QE in the future if the economy falters will be enough to quell investor jitters.

My belief is that, regardless of what the Fed does or does not do, U.S. markets are superheated and overdue for a sizable correction. In my experience, markets that become overextended in this way find any excuse to correct. Virtually every investor who owns stocks has a profit currently. If the market begins to fall, there will likely be a stampede of selling, as investors scramble to avoid giving back what they have accrued on paper. Selling will likely accelerate and intensify, feeding upon itself until stock valuations fall to more realistic levels.

Stocks often overshoot on the downside, just as they appreciate well beyond their fair value (as they have to-date). If a substantial correction comes, there should be an attractive buying opportunity for those with cash available and the foresight to enter the market when most are panic-selling. Formulating a game plan ready for implementation in the event of a correction is a prudent strategy, whether investors believe there will or will not be a correction.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.

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