Lessons from Japan
Carta MAR? 2024 - Alkimia Capital
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Carta MARZO 2024 - Alkimia Capital
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Lettre MARS 2024 - Alkimia Capital
More, more, and more. Equity developed markets continue to show strength, ending the quarter with gains exceeding 10%. The dollar (+2.30% vs the euro) also contributed, though not decisively. And even gold sees an increase of +10.30% (in euros)!
Recent market performance: 31/12/23-31/03/24
Fixed income lags behind, with the Bloomberg Global Aggregate index falling a modest -0.40%, still far from the previous highs at the end of 2020 (cumulative falls still exceeding 11%). However, fixed income has been more of an exception. Stocks, Bitcoin, and gold have reached new highs, with one case being especially popular: the Nikkei 225.
The Nikkei 225 is a representative index of the Japanese stock market, created in 1950 shortly after the market opened after World War II. The Japanese boom of the 1980s saw the index reach 38,957 points (December 29, 1989), and it wasn't until February 22, 2024, that this level was surpassed. In fact, the Japanese stock market once accounted for over 40% of global capitalization, while currently, this figure is close to 6%.
At that time, it seemed that Japanese companies and the economy were going to conquer the world, and valuations soared. Not only stocks. At one point, it was estimated that the Tokyo Imperial Palace was worth as much as the entire state of California! The bubble eventually burst, and reality did not live up to the lofty initial expectations.
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As a result, Japanese stock market performance has been very poor and has often been used as an argument by detractors of investing in equities, as it contradicts popular dogmas such as “stocks always rise in the long term”. In fact, the recent gains don't change the picture much: 34 years is a long time, and when we talk about the long term, we usually think of shorter periods. In any case, the Japanese example can teach us a thing or two about how markets work.
First, we need to talk once again about the price we pay for assets. The Nikkei in 1989 traded for 60 times the underlying earnings of companies, a figure well above what is considered normal (currently we are at 16x). Paying a high price usually takes its toll, and Japan has not been an exception.
Second, the figures related to the Nikkei 225 ignore the impact of dividends. If we take them into account, the index would have surpassed previous historical highs years ago.
These two points can help us explain two realities that coexist in the market and gradually shape the returns we will obtain in the long term:
1) The price the market is willing to pay.
Assuming constant profits for a moment, the 60x earnings multiple of the Japanese stock market meant recouping the investment in 60 years. It's a level much higher than historical averages, which are around 15x earnings. Thus, a healthy market willing to pay only an average multiple (15x) would have implied a significantly lower price for the Japanese stock market: approximately 75% lower! (15x/60x -1).
2) The underlying generated flows.
Even under the simplifying assumption of constant profits (which grow in the long term), paying 60 times earnings means that, in one way or another, the companies we own generate an annual return of 1.66% (1/60: we paid 60 and companies make a profit of 1). Companies will not always return profits to shareholders, but ownership means participating in a process of capital accumulation. Thus, companies generate a profit and part of it is reinvested in the business, which in turn generates more future profits. And dividends, despite being ignored in the design of some stock indices, are very real and can accentuate this accumulation process.
Therefore, we can say that yes, stocks rise in the long term, but if they do, it's because we participate in a capital accumulation process determined by the combination of valuation dynamics (1) and value creation dynamics (2).
If we return to recent market developments, what we have experienced recently suggests that we are more in a momentum market ("I buy because others are buying") than in a fundamentals market ("I buy because the underlying assets are worth it"). This type of environment tends to be a challenge for the investment process we follow at Alkimia Capital, because we guide much of our decisions by the fundamental value of the underlying assets.
So, we continue to think that stock and credit asset valuations (corporate fixed income) are demanding, but we are not surprised by the strength of gold, which responds to its refuge condition against high geopolitical uncertainty and lack of fiscal discipline.
The new highs have made headlines and caught investors' attention, but the truth is that gold has been showing relative strength for some time now. A common indicator we use is the relationship between real interest rates (nominal interest rates minus inflation) and gold. The rationale is as follows: "When interest rates rise, the attractiveness of gold decreases as it does not pay any interest, and the opposite happens when rates fall." This relationship explains some of the previous movements seen on gold, but there has been some disconnection for a few quarters:
Attempting to explain the movements of gold with just one factor is undoubtedly a simplification exercise, but we believe that the decreasing importance of monetary policy in favor of fiscal policies is key. Current deficits are not normal and anticipate a macroeconomic dynamic quite different from that experienced during the 2000-2020 period. If so, the price of gold may be warning us about imbalances that are currently being ignored by other markets, so perhaps a more cautious and balanced approach than usual is needed. This may be more complicated than it seems. Many of the indices and usual references have gradually accumulated biases, and as eventually happened in Japan, they can end up taking a toll.
Historically, the way we design portfolios at Alkimia Capital has proven to be more balanced, as we consistently prioritize the preservation of our clients' capital, and this is only possible if we have portfolios prepared for adversity. The incorporation of assets such as gold and alternative funds is common and responds to the goal of achieving this balance. In addition, we remain particularly attentive to the growing valuation risks in traditional stock markets, favoring segments such as small and medium-sized value companies and emerging markets, and maintaining a portfolio of high-quality fixed income, which should have defensive properties if the economy slows down or defaults increase.