Japan 1-2-Three

Japan’s three back-to-back crises are causing turmoil in a market that had run up about 25% from the lows of August before topping out in late February. I’m not saying that the market in February was “priced for perfection,” but clearly investor fears of being out of the market stuck in low yielding cash, replaced a fear of stocks. Encouraged by mounting evidence of economic recovery, the market at one point had climbed nearly 7 percent in 2011. Now it is back down close to breakeven on the year. Roughly half of the decline, thus far, happened prior to the crisis in Japan, probably as a result of international struggles elsewhere and the rise in oil prices that they precipitated. So Japan didn’t cause the sell-off, but it is making it worse.

First Japan had an earthquake. Then a tsunami hit. Third, the tsunami triggered a nuclear meltdown crisis. SmartMoney’s Brett Arends blog post is probably right on target. While tragic in the loss of life and serious in its economic implications for the Japanese economy and elsewhere, the economic impact of the quake and tsunami should be relatively short-lived, especially for U.S. investors. In fact, the markets took the first two events in stride, with the U.S. market closing up on the Friday that the news first hit.  Fidelity's research group seems to have drawn a similar conclusion in its recent special report.

It is the nuclear crisis that hit the market hardest. As of mid-day on Wednesday, the plants have not experienced a Chernobyl-like disaster. There’s something in it for both sides of the nuclear power debate. The General Electric designed technology has thus far, generally speaking, contained the meltdown. Proponents of nuclear power will probably argue that the engineers are able to design plants that came through a severe and rare earthquake/tsunami disaster and generally contained the dangers within. Opponents of nuclear power will note that for the past few days, the world economic system has been set on a precipice as we all wait to see whether the meltdown spirals out of control.

To me, the market has over-reacted to the meltdown. While Jim Cramer’s observation that “nuclear energy is dead in the United States” may or may not be true, he was surprised that the utility companies weren’t selling off more, while I am surprised that they’ve sold off the way they have. Companies can be valued in different ways, but two of the most basic are based on assets (liquidation value) or on cash flow (earnings). If utilities are being based on assets, then I would agree that those with nuclear plants are probably worth less after the Fukushima Baiichi meltdown than before. However, the earnings power of existing plants probably isn’t impacted much at all, unless the market is forecasting some expensive retrofit – which isn’t the case as far as I know. Generally, I think that utilities are valued based on earnings power, and the sell-off they’ve had is unwarranted.

Much of this week’s market turmoil, I think, settles out over time. Indeed, the market was toppy, having moved up 25 percent in six months, and the market was looking for reasons to take a breather. As long as the Fukushima plant doesn’t go all Chernobyl on us, I think that the market will use the crisis as an excuse to flatten out a bit, as stock prices give the real economy a chance to catch up, and nothing more.

The most interesting question, to me, is whether the Japanese can fund the stimulus that they’ve committed themselves to providing. In the past few years, Japan has transitioned from a nation of savers to a net borrower, at least at the government level. Having promised the financial sector nearly $200 billion in funding, so companies don’t have to sell off assets in order to fund reconstruction, an interesting question is, “who will buy that paper?” John Mauldin is a much followed strategist who describes Japan as “a bug looking for a windshield.” As Europe continues to wrestle with its own bad debt issues, and with the U.S. borrowing money like there’s no tomorrow, who is left to finance Japan’s spending?

Mohamed El-Erian, who is widely quoted about international fixed income markets and as PIMCO’s CEO makes a lot more money than I do, feels comfortable that Japan can fund its promised stimulus efforts. Hopefully, he’s right. To me, the most interesting question isn’t, “what’s the future of nuclear energy,” which is a sector that can easily enough be avoided. In fact, our portfolios’ gas holdings have fared relatively well as more people move into the “gas as clean energy” camp.
 
To me, the most interesting question is, “what’s the impact on global interest rates,” because if this is the trigger that sends all sovereign interest rates higher, the problem will be very widespread and will definitely impact global equity markets. 
 
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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