Fall-Out Implications for Investors

Eric Linser, CFA | March 17, 2011

I would like to quickly share my thoughts on the events in Japan this past week.

First, let me say that my heart goes out to everyone that has been affected by the horrible disaster.

My role as an advisor is to opine on the financial aspects of the disaster, the events occurring here at home (be it the US, or California), the Mid-East, or the emerging markets. Heck, anything that can affect the management of my clients' wealth is something I have to take into consideration.

The Fall-Out

The worst earthquake in the history of Japan has caused seismic shocks not only to the local economy, but global financial markets as well. Investors of all kinds are being affected by the disaster, which has now morphed into a potential radiological catastrophe, as damaged nuclear energy plants leak radiation into the atmosphere.

"What now?" is the thought of many, as the world's 3^rd largest economy reels in an aftermath that, given the radiation dangers, is still not yet fully clear.

It’s important to take a look at the short-term and long-term effects of the earthquake on global markets as well as major currencies. Indeed, while panic selling has already taken hold, buying opportunities for investors are taking shape.

Japanese Market

As you may imagine, Japanese stocks have so far been the hardest hit. The Nikkei, Japan’s broad stock market index, is on the verge of moving into bear market territory, as it flirts with a 20% drop from its February high. It fell 12% in the first 2 days of the week, its worst two-day drop in over 20 years. In comparison, here in the US, the S&P 500 has fallen ~ 6.2% from its recent high of February 18^th through March 16^th.

When a natural disaster of such magnitude strikes, a sell-first-and-ask-questions-later dynamic takes hold. Indeed, investors are dumping anything and everything Japan-related. As cooler heads prevail, investors often bet that an affected country’s GDP will increase in the wake of any destruction, as governments and private industries pump money into the rebuilding process. This outcome is likely in Japan, but it could be months away before the spending shows up in Japanese stock prices.

In the 6 months following the 1995 Kobe earthquake in Japan, the Nikkei lost 25% before finding a bottom as the rebuilding efforts boosted the economy. The recent earthquake and its aftermath -- particularly the radiation leaks from damaged power plants -- appear to be far more destructive than Kobe’s disaster, and thus could lead to bigger near-term losses for the Japanese stock market.

The Japanese Yen

Most investors assumed Japan’s currency, the yen, might fall given the broad scope of the natural disaster. But that hasn’t been the case because as residents prepare to rebuild the country, they must first buy yen, and if they had overseas investments, they must repatriate those assets.

On Tuesday, the yen rallied to within striking distance of an all-time high. In the 3 months following the 1995 earthquake, the yen gained an astounding 18%. While I’m not expecting a rally that large in the coming months; the yen could very well hit new all-time highs and be a safe haven for investors. I know some investors may want to leverage up and short the yen and go long the US dollar, but the time may not be quite right to do that.

Nuclear Issues

On top of the mass casualties and destruction caused by the earthquake, the damaged nuclear power plants loom as a major concern for Japan and the world, as the radiation rescue workers have detected risks being carried by the wind to areas both in Japan and far away. This turn of events has caused investors to run from any stocks related to nuclear power generation.

I also made the same move. While Green Valley’s investors didn’t have direct exposure to Japanese stocks, I did hold one uranium mining stock that I promptly sold Monday morning. Most stocks tied to uranium or nuclear power are trading down, minimally, 20% since last Friday. While we could debate the future of nuclear power in the US and around the world, I believe it’s best to sit on the sidelines for now regarding nuclear investments.

To Sell or To Buy?

After a natural disaster and a subsequent market sell-off, the debate begins as to whether investors should turn into vultures and start buying depressed stocks. Or conversely, should investors continue to be cautious, selling and not consider buying until all the unknowns are gone?

I tend to fall in the middle – reviewing my positions and not making any errant decisions. I’m definitely not the panic-selling type of investor because, as history shows, this is typically not the best strategy. Indeed, it often results in selling at the lows. At the same time, being a vulture is difficult, because you have to have money to lose and have the patience to let the market rally if you are too early to the party.

Japanese Stocks

As far as Japan is concerned, I would hold off on buying any Japanese-related stock funds for a couple weeks. There could be more downside before a rally occurs. Add to that the strength of the yen, and Japan’s export-driven economy could be on the ropes for some time. And, my worst-case scenario (Black Swan) is that Japan will have a debt crisis that will make Greece, Portugal, Spain and Ireland’s problems (in aggregate) look irrelevant in comparison. Japan’s public debt is twice as large as its $5 trillion economy, and was already worrisome to credit rating agencies. With more debt financing inevitably to come, it might not be a question of Japan being too big to fail, it could be a question of it being too big to save. Collectively, the world’s central banks will have to intervene, and hopefully they do it sooner than later.

On a more optimistic note, Japan proved their resilience after World War 2, rebuilding and creating an incredibly vibrant economy (think - Honda, Sony, or Toyota). Japan has come back before, and will again. For now, getting food, shelter and medical supplies to the stricken area is the country’s first priority, but soon thoughts will turn to repairing and rebuilding. This, in turn, will create jobs and real economic growth.

World Markets

The reaction of other world markets to Japan’s financial panic appears to be overdone. This is a reaction to perceived higher risk premiums by investors worldwide. We’ve been buffeted by the shock that disasters of this magnitude can happen in civilized places like Japan. If it can happen to them, it can happen to us. Nothing is guaranteed, but the probability is that nothing like this will happen again for many, many years. This was a once-in-a-century occurrence. All we can do is prepare the best we can.

Maybe the closest parallel in the minds of Americans is the reaction of the markets to the 9/11 attacks. While the loss of life, the property damage, the impact on the broader economy were all far smaller from that event than from Japan’s current disaster, people reacted the same way -- they panicked. What good did it do them? None. Within a couple of months the market had recovered all its losses from immediately after 9/11. The recession that followed had no direct bearing on that event, but the lows of the bear market weren’t all that far below the lows the week after 9/11.

It is best that investors stick with their plans and look at these types of events as opportunities rather than crises, then they are better prepared to react correctly. No one brags about selling on Black Monday, but that is exactly what a lot of investors did. No one will be proud of selling Japan today.

Is now the time to get back into the markets? My belief is to keep one’s investment strategy active, especially during times of uncertainty and look for over-reactions and opportunities. Yes, there will be supply chain disruptions from halted businesses and factories shutting down in Japan leaving gaps in economic activity in other parts of the world. While I would (and will) jettison securities that could struggle with sales and earnings growth that is more than temporary, history suggests that the current decline will be short-lived.

I’ll save discussion on other matters for another day.

My condolences go out to the victims and the bereaved.

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