Black Swans and Japan
Nassim Nicholas Taleb, a New York University Professor, wrote a best selling book called The Black Swan, which illustrates that history is full of events that cannot be predicted by trends. This theory is based on a metaphor that if an event is a surprise (society does not expect), it will probably of have a major impact positive or negative on society. Conversely, after the event occurs, it is rationalized through hindsight, and there is no major affect on society, because the event has already occurred. Professor Taleb explains that history is hard to predict and unforeseen events are beyond the capabilities of normal statistical measures. As investors we can only implement risk management techniques to limit downside risks, but more importantly be opportunistic once a ‘black swans’ occurs.
Over the last two weeks the markets have been reeling with the unexpected earthquake (9.0, and the 5th worst in recorded history) resulting in massive physical destruction in Northern Japan and the failure of two Japanese nuclear reactors. To make matters worse the Middle East uprising in Libya has now escalated to involve the United States enforcing a no-fly zone over the Northern part of the country. Needless to say, the global stock markets sold off last week in anticipation of a global economic slowdown and the risk of higher energy prices.
Was the market sell off justified last week? Yes.
I have been suggesting that the financial markets have been overvalued, overbought, and over-bullish with extreme investor confidence in the sustainability of the global economic recovery. When financial markets are at their peaks or multiyear highs, any unforeseen or ‘Black Swan‘ event will cause richly valued securities to be sold in the short term. The market sell-off over the last 2 weeks was warranted, but as we have seen over the last couple of trading days, it seems that the all clear bell has rung and investors are piling back into the market. I must admit, the events of the last two weeks are definitely cause for concern, and the financial markets needed to correct, but have they corrected enough to justify investor’s renewed optimism?
First, lets examine the impact of the earthquake and the tsunami on Japan and its affect on the global economy. The Japanese stock market has been on a steady decline for nearly three decades with short-term rallies within its long-standing bear market. The Nikkei 225 peaked in 1989 at 38,916. The index is currently around 9,000, almost exactly at the same point is was in 1984 (its inception) more than 25 year ago. Japan has never been able to fully recover from its financial crisis of the 1990’s and its insatiable appetite for government borrowing has never really amounted to any meaningful, domestic, economic recovery. For the last two and half decades they have been hampered by a deflationary environment that has resulted in poor corporate profits.
However, since the global market stock market lows of 2009, Japan’s economic situation has improved. The Nikkei 225 (Japan’s version of the S&P 500) has forecasted a much better earnings outlook over the next several years. In fact, the companies within the index have recorded better overall annual earnings increase over the last three years. According to Bloomberg, since 1998 the Nikkei 225 has an average P/E ratio of 67.70 and a low P/E of 10.71 at the market low in October of 2008. Currently, the index has a P/E ratio of 17.14. So, one can conclude that Nikkei 225 is rather cheap relative to historical valuation.
This brings me to my final point. There is no doubt the devastation that has occurred in Japan will cause major economic set backs in the near term, but the overall long term outlook in Japan will improve drastically with the increased economic activity that will ensure once the overall damages have been assessed. Black Swan events usually create tremendous opportunity once society and investors assess that the end of the world is not going to occur. Also, empirical studies conclude that after Black Swan events occur prosperity and positive economic activity usually occur. For instance, after the terrorist attacks on September 11, 2001 in the United States, the stock markets around the world sold-off dramatically. The NYSE closed for a short period of time, which is an extremely rare event. After a grieving period and a reassessment of the ‘new’ era of terrorist risk, the US economy came roaring back and forced the financial markets to capitulate and ended the bear market that began in September of 2000.
The Japanese governments have already injected nearly $200 billion into the economy and the total damages and the estimated cost to rebuild the country’s infrastructure is estimated to be between $300 and $500 billion. Most economists believe that Japan’s overall GDP will only result in a loss of 0.5%, and future GDP growth should average closer to 2.0 - 2.5%, which will nearly double the economic activity over the past decade. With the Japanese stock market trading at the same level it was since its inception (1984), P/E ratios are near all-time lows, and the massive amount of potential foreign investment and rebuilding activity, this may be an excellent time to capitalize on the potential growth that may occur because the ‘Black Swan’ that flew over Japan.
