Endaka & Nikkei Put Options Obvious Macro Plays in Japan

"Promises that you make to yourself are often like the Japanese plum tree - they bear no fruit."

Francis Marion (1732-1795)

Japan Inc. is back in play. But not in the 2003 recovery story kind of way. This time, it is the story of paparazzi waiting outside the emergency ward at a hospital with their scythes (and not cameras) sharpened up, ready for another blow to the body of a weakened economy.

The bulk of the paparazzi is comprised mainly of foreigners (security companies, insurance companies, asset managers and hedge funds). As TSE/Osaka stock market volumes continue their multi-year long declines retail investors have joined their domestic institutional counterparts turning their backs on Japanese stocks, especially FX-sensitive exporters.

Curiously, the % of trading value of stocks traded on Tokyo, Osaka and Nagoya markets by foreigners has increased to over 50%. Looking at TOPIX alone, the foreigner component is holding steady around 50-55% since 2008 (data: DIR Investor Guide, July 2010).

The macro trades du jour consists of buying the yen against all currency pairs and buying put options on the Nikkei and TOPIX stock indices. The trades are largely directional and foretell a particularly negative view on a country that used to lead global production of high value autos, consumer durables and was the envy of the world for high growth and high tech.

Korea and China Inc. have taken up the technological challenge and in many cases beaten their Japanese competitors to market with products for western consumers. Sony is now an after-thought for the bulk of post-recession, over-leveraged global consumers.

Expect bank and real estate equities to be picked apart if markets do in fact fall back to the lows of 2002/03. At that point, authorities would be best served to open up the economy in a new and radical way to allow inward investment by neighboring SWFs. That means that the time may be close at hand when one of the biggest banks in Japan may be owned by the Chinese. Sounds crazy? The world is changing fast.

In the meantime, expect macro funds and multi-strategy players (mainly out of NY, London and HK) to continue to make directional plays on Japan especially if there is a further 20% decline in the Nikkei Index and a move in US$/Yen through the 79.75 all time high. At those levels central bank intervention is anticipated and likely, although for it to be effective will require the cooperation of the Bank of China and other entities that have been big buyers of yen and JGBS in recent months.

All told, the long-biased long/short Japan equity hedge fund is in for a rough final performance stretch in 2010. Expect asset losses.

When the Nikkei is close to 7,000-7,500 one might start to see again some of the world's biggest global investors including SWFs and petro-dollar investors pile back into Japan. The authorities would be wise to start preparing road-shows to encourage inward investments over the coming 12-18 months. Going long is about to be the right strategy in Japan - just not right now. Mahalo.