Investors are voicing concerns that stocks are getting increasingly erratic and nonfundamental. It is a chicken and egg situation: foreigners won’t buy till they see stocks behaving ‘normally’ but they’re not, so they don’t; stocks should mirror earnings, but they are concerned that is no longer happening. They suggest that the problems started with the ramping up of BoJ buying – that there appears to be a crowding-out effect in many bond markets but that Japan seems to be the only place where it is happening in the equity market.
Liquidity appears to be abundant, but it disappears when you try and make use of it. This feeds on itself when the market starts to move. The result is a skittish, unidirectional, momentum-driven market. Buying programmes appear to have put correlations in place that didn’t exist before and make no sense. Where has this erratic behaviour come from? It appears to result from the combination of the exiting of foreign investors and the simultaneous ramping up of passive buying by the BoJ and GPIF. Fortunately, companies are combatting the problem with record buybacks.
Foreign selling creates a vacuum
Foreigners sold ¥6.0tn in 2018. The main seller was Europe. The only year they sold more was 1987 (over the following two years, the Nikkei rose 80%). Over the past year, the higher the foreign ownership, the worse a stock’s performance. The Japanese market badly lacks an active domestic investor base to create a support level for falling stocks, particularly when foreigners sell. That presents opportunities.
BoJ ETF buying is Gresham’s Law in action: bad money driving out good
Foreign selling was more than offset by ¥6.5tn in BoJ ETF buying. Whereas the Topix PE is highly correlated with foreign buying, accelerating BoJ buying has been consistently met with multiple contraction; the BoJ has a highly predictable response curve and it appears algos are selling into its buying. BoJ buying was intended to reduce the ERP but it has risen to new highs. BoJ ETF buying is matched by GPIF passive buying: the GPIF cut its active weight to just 9.6% despite saying it would raise it. That too is damaging price discovery.
Whereas central-bank involvement drives down the market’s volatility, it appears to raise it significantly for smaller stocks. The much-trumpeted JPX-Nikkei-400 index actually underperforms the Topix. JPX gives evidence this is because quants pre-buy threshold stocks, so its beneficial effect is priced in before they enter – whereas their newer mid & small index firmly outperforms, highlighting an opportunity. Companies are reacting to erratic sliding share prices with buybacks that significantly exceed what we have seen before.