About five years ago… Investors around the world began piling into Japanese stocks.
It was a surprising move.
Japanese stocks have been a virtual graveyard for capital since the last 1980s. That’s when Japan’s big real estate and investment bubble collapsed. The Japanese “Dow” – the Nikkei 225 – briefly soared from around 10,000 to more than 40,000… and then collapsed.
Over the next 20 years, every rally in Japan was followed by still yet another, bigger decline.
By 2009, the Japanese stock market was still down over 60% from its peak. (See chart to the right.)
So what was it that spurred global investor interest a few years ago?
Did Japan’s economy suddenly come back to life? No. Japan has consistently had the worst economy among the G20 group of major economies. Economic growth hasn’t been above 2% since 2012.
Was there some breakthrough in solving Japan’s big demographic problems? No. Japan’s population is declining. Japan is expected to lose more than 30% of its population by 2050.
So… why were investors suddenly interested in Japan?
Japan Went ‘John Law’ With Its Central Bank
John Law was the Scottish rogue and murderer who convinced the French King Louis the XV to allow him to set up one of the world’s first central banks, the Banque Générale, in 1716.
The bank brought paper money to France and allowed the king to finance his soaring debts. Having saved the king’s bacon, Law convinced the king to give him a monopoly on trade with the new world – in Louisiana.
The combination of virtually limitless paper money and the hottest initial public offering (“IPO”) in history saw Law pay off the entire French government’s debt just by issuing another 300,000 shares of the Mississippi Company. The share price, which went public at 75 livres, eventually rose to 15,000 before the peak.
It was this bubble… the forerunner to every modern financial bubble… that saw the creation of the word “millionaire.”
So naturally, Japan captured investors’ attentions when it announced in 2012 that it would vastly increase the asset purchases of its central bank…
And its central bank – the Bank of Japan – wouldn’t just buy Japanese government bonds…
Japan was the first major economy in the world to see its central bank begin to buy huge amounts of stocks. $30 billion or so per year.
In an attempt to make sure these purchases weren’t politicized, the bank explained it wouldn’t buy stock directly (it wouldn’t pick stocks). It would only buy via exchange-traded funds that allocate capital according to the structure of various preexisting indexes.
As you’d imagine, this policy has produced a boom in Japanese stocks. And it has attracted a lot of “hot money” from around the world.
Buying Japanese stocks between 2012 and 2016 (as they doubled) was virtually risk-free, thanks to the size of the Bank of Japan’s campaign. As Jesper Koll, who runs fund sponsor and asset manager WisdomTree Japan, explained to the Financial Times: “There was no other equity market in the world that covered this sort of fundamental downside protection.”
There’s little doubt these huge moves will continue. Last year the Bank of Japan announced it would double its purchases of shares, spending at least 6 trillion yen ($60 billion) on stocks.
John Law would be impressed.
But remember… About a year after the Mississippi Company went public, food prices began to soar. To stop the runaway inflation, Law had to raise interest rates. That pricked the bubble in Mississippi’s stock. Within a few weeks, the whole scheme collapsed. Food prices soared another 60%, the king outlawed gold, and shares of the Mississippi Company collapsed.
You Can’t Print Prosperity
Keep a careful eye on the markets, and especially on the outlook for inflation. It’s coming.
And in the meantime, look at Fast Retailing (9983.T) on the Tokyo Stock Exchange. If you’ve ever seen a pro golfer wearing a brand you can’t pronounce (UNIQLO), then you’ve seen the company’s products. Golfer Adam Scott, for example, is sponsored by UNIQLO, among other major athletes.
You can think of the business as something like the “Japanese Under Armour,” a fast-growing sports apparel business.
But unlike Under Armour (UAA), which has very few stores (just 29), Fast Retailing continues to invest heavily in actual physical locations. It has opened more than 1,000 stores since 2012 and now operates over 3,000 stores throughout Asia. That’s nearly twice as many locations as Target has in the U.S. (1,807). (See chart to the right.)
Physical retail has been a tough business for about a decade, as more and more shoppers prefer to buy everything from books to shoes online. Fast Retailing, on the other hand, has seen its share price soar.
Since hitting a low in 2011 below 1,000 yen, the stock price has gone virtually straight up… climbing over 6,000 yen at its recent peak. This soaring share price has helped the company gain access to billions in additional, new capital.
In 2016, Fast Retailing took on $2.4 billion in debt (moving its debt to equity leverage ratio from 4x to 47x) and the company’s CEO has announced plans to spend another $11 billion on a huge global expansion, moving into the U.S. and European markets.
What is Fast Retailing’s secret?
Is it the mystery of embroidered shirt patches nobody can pronounce? Is there something unique about its Vietnamese-made shirts…?
No, of course not. What’s special about Fast Retailing, at least in the eyes of global investors, is its nominal share price. Not its market capitalization, the sum total value of its shares. The share price itself. Compared to its peers, Fast Retailing has a huge nominal share price, around 37,000 yen.
Why should nominal share price matter?
You might have noticed the sudden popularity of very large share prices. Amazon and Google recently both saw their share price racing to $1,000. (Google won, twice – its shares previously passed the $1,000 prior to its 2014 stock split.)
But they’re not the only companies that have deliberately let their nominal share price soar. There’s a host of super-expensive nominal share price companies today, like Priceline (PCLN), at $1,890, NVR (NVR) at $2,395, Seaboard Corp (SEB) at $4,150, AutoZone (AZO), at $600, and Intuitive Surgical (ISRG) at $930.
Huge nominal share prices haven’t always been popular. You might remember that during the dot-com boom of the late 1990s, investors would pile into companies that were announcing a stock “split.” That’s when a company increases the number of shares outstanding, sometimes by 100%, by simply exchanging one of your shares for two new ones.
Share splits don’t change anything about the business. It doesn’t make the company more valuable in any way. The share price should simply fall in half as the company’s shares outstanding double. But back then, investors believed that simply making the stock more affordable would lead more investors to buy it… and that alone would push the total value of the stock higher.
Today, however, most people are investing through exchange-traded funds (“ETFs”). Many of these funds are structured according to various indexes. And some of these indexes are “price-weighted,” meaning that the capital is allocated according to nominal share price.
That is, some people are investing, knowingly or unknowingly, into stocks simply because the nominal price is high.
They’re not buying because the business is undervalued…. or because it pays a good dividend… or because it’s growing fast. They’re buying simply because the nominal share price (which conveys zero information about the relative attractiveness of the investment), is a very large number compared its peers and thus is more likely to attract subsequent capital.
Said another way, the “greater fool” is more likely to buy a big nominal share price stock over any other stock.
Thus, the same kinds of management teams that used to split their stock to gain the attention of investors are now not splitting their shares for the exact same reason. And in Japan, that kind of investment rationale has been taken to an extreme…
In Japan, the central bank is the “greater fool.”
Japan’s central bank – the Bank of Japan – has been buying around 3 trillion yen ($30 billion) worth of stocks via ETFs each year, radically warping the equity market. The Bank of Japan focused its buying on ETFs that were structured according to the Nikkei 225 index, which is a “price weighted” index, much like the Dow Jones Industrial Average.
Again, in a price-weighted index, the larger the nominal share price, the larger the allocation in the index. Fast Retailing, with its huge share price, makes up about 8% of the Nikkei index, a huge position relative to the total size of its company.
For comparison, consider that Fast Retailing makes up only 0.3% of the larger Topix index, where allocations are made according to firms’ total market value, not merely the nominal price of their shares. (See chart to the right.)
It didn’t take long for investors to figure out how to take advantage of the policy.
CLSA – one of Asia’s biggest brokerage firms – recommended clients sell shares of auto giant Toyota (7203.T), one of Japan’s best global companies. It replaced Toyota in its recommended portfolio with… Fast Retailing, purely because of its huge weight in the Nikkei 225 index.
The broker also recommended Japanese communications giant Softbank (9984.T), which is pursuing a risky, highly leveraged global acquisition strategy. It wasn’t an endorsement of Softbank’s strategy. It was an endorsement of its nominal share price. You see, after Fast Retailing, Softbank is the second-highest-weighted stock in the Nikkei 225.
And sure enough, Softbank’s shares have soared, thanks to the Bank of Japan’s investment scheme. Softbank’s stock was “dead money” due to the collapse of the tech sector until 2012. But once the Bank of Japan ramped up its equity purchases, Softbank’s stock has more than quadrupled, moving from around 2,000 yet to over 9,000 yen. (See chart to the right.)
The decision to use the awesome power of a central bank to invest in the stock market won’t only hurt investors and “stock jockeys.”
There Is No Up, There Is No Down
Our capital markets are supposed to be “efficient.” That is, modern financial theory explains that by allowing capital to be allocated by the inputs of millions of investors, vast amounts of disparate information can be processed and capital can be allocated where it’s needed most, so it can be used most efficiently.
But allocating capital according to nominal share price? And putting the most amount of capital into the stocks with the highest nominal share price? That’s not likely to be efficient at all. It seems utterly ridiculous, in fact.
Why would a company with a high share price be particularly adept at putting more capital to work? What if they’re merely good promoters and have figured out a way to game the system?
In 2013, riding the wave of the Bank of Japan’s investing spree, Softbank bought $21 billion worth of America’s fourth-best wireless telecom, Sprint (S). Immediately after the purchase the shares began to decline and eventually fell in half. Sprint, meanwhile, has seen its network investment costs explode higher (reaching over $9 billion last year) and has had to borrow over $30 billion to remain competitive.
Meanwhile, a price war has broken out with the leading vendor of wireless service, Verizon (VZ), knocking of Sprint’s flat-rate pricing offer.
During the 2015-2016 correction in corporate bonds, Sprint’s most recently issued debt fell to $0.75 on the dollar, indicating that most investors don’t believe the company is likely to repay these obligations in full.
Dennis Saputo, a senior credit analyst at Moody’s Investors Service, told the Wall Street Journal that Sprint hasn’t made a profit since 2006 and will probably run out of money before mid-2018. If Sprint defaults, Softbank will likely lose all of its $21 billion.
And what about Fast Retailing? Will building new retail locations all around the world – as Fast Retailing intends to do – prove to be a wise use of capital?
Will Japan’s enormous equity purchases, which have supported both Softbank and Fast Retailing, generate real economic growth, by stimulating the economy? Or will this huge inflation only promote reckless speculation and bad investments?
What will happen around the world as more countries to try to emulate Japan? Can you successfully back a currency with the shares of highly volatile companies?
In 2014, Switzerland’s central bank began buying equities, too. But since its domestic economy is so small, it decided to invest globally…
Today, the Swiss central bank owns more than $60 billion worth of U.S. stocks, including a huge $1.7 billion position in iPhone maker Apple (AAPL) and $800 million in social-media titan Facebook (FB). And the Swiss bank continues to expand its balance sheet at almost $100 billion a year. Its total balance sheet has now grown to around $700 billion. That’s almost $90,000 in securities per citizen… and growing every year… just by printing more Swiss francs.
In M.C. Escher’s most famous prints, the viewer can’t figure out which way is up. In Relativity, a maze of stairs interconnects – each with a different gravity orientation. The paths wind and intertwine. There is no “up.” There is no “down.” (See image to the right.)
When central banks around the world begin to spend trillions on financial assets, the same thing happens to the world’s financial markets. When stocks become the basis of our global financial system… stocks are the money we use… there’s no way to exit the risks of the equity markets.
There’s no up. There’s no down. There’s no limit to the
resulting possible inflation. And there’s no way to predict when the value of the currency will collapse. When money has no firm value, it’s impossible to know what something’s actually worth… or if an investment makes sense… or is safe.
Today, as stocks rise by huge amounts all over the world, investors are cheering these central-bank moves…
But they may rue them tomorrow. After all, if these investments sour, how will investors flee to safety… when inflation forces central banks to stop the inflation and to increase interest rates… how will investors find safety?
When the Swiss franc is backed by shares of Facebook… and the Japanese yen is backed by Fast Retailing… and the U.S. dollar is backed by mortgages… what firmament will investors seek in a crisis?
Official currencies? They too will be tied to the success (or failure) of Apple’s new phone… or of Softbank’s latest gamble. Like an Escher maze, there may be no conventional way out of the next crisis. There may be no way to get to level ground.
We’ll look at one possible “out” for investors in our July issue of American Consequences. We’re focused on gold, oil, and even new forms of money – like Bitcoin. But whatever happens next, just remember… the soaring stock prices you’re seeing aren’t real.
They’re just stairs – in a giant financial Escher print.
Porter Stansberry founded Stansberry Research in 1999 working on a borrowed computer at his kitchen table. Since then, he has built the firm’s flagship newsletter, Stansberry’s Investment Advisory, into one of the industry’s most widely read publications.
Today, Porter is well-known for doing some of the most important – and often controversial – work in the financial advisory business.