Topix: Sector rotation implies pause, not stop

by SR on April 12, 2012

Today I have taken another look at Topix sector index performance and added what is in effect an update to my previous post published at the end of February.

Conclusion: you should look at rubber stocks and auto parts plays. By rotating out of the high-beta stocks (e.g. brokers) that drove the Japanese market up from the November 2011 bottom and by rotating into defensives, market participants are signalling a new phase. Once they have caught their breath after the recent surge and even more recent correction in the market, I expect investors to start systematically looking for those stocks that are backed by solid growth prospects. It is likely that Japan autos, auto parts and rubber stocks will make their list. My top picks in those latter two sectors would be Denso and Bridgestone respectively.

Brokers, autos, steel & insurers made the running up to March

Back at the start of March I wrote a post on the performance of the 33 different Topix sectors since the market bottom in late 2011. A lot was as expected but there were a couple of real oddities.

Most things made some kind of sense, of course, such as the strong performance of brokers like Nomura and Daiwa. After all, a fund manager looking at the market lying flat on its back in late November 2011 might have thought that the European problems had been resolved, at least temporarily, and she may have wanted a call option on some kind of recovery. Buying securities stocks would have been one logical way to go about that. So, the Securities and Commodities Topix sector rose by 58% between 24 November 2011 and 29 February 2012, compared to a rise of 18.4% in the Topix index, which is shaded in green below. (Click on the graphic for a larger image.)

topix industry sector performance in percent since trough

The weaker yen buoyed auto stocks like Toyota and Honda, which in turn pushed up the Transport Equipment index (+35% over the period just mentioned) and Iron & Steel – perhaps benefiting from the strength at their customers the auto companies – rose 33%. Insurance (+30%) also had a good run. I’m guessing that market participants assumed in the case of insurance stocks that after the nightmare of 2011 – Tohoku earthquake, Thailand floods and exposure to Europe – 2012 would have to be better. At the bottom of the table came a list of sectors dominated by classic defensives: telecoms stocks, railways, fishing and agriculture, pulp & paper, foods and utilities.

So far so reasonable. There’s at least some justification for what moved and what didn’t move. On the other hand, some sectors left me scratching my head. What to make of the 57% increase in the Marine Transport sector, especially given the fact that the BDI didn’t have a significant move over the same period? I didn’t know but I was skeptical, calling it “irrational exuberance on the waves”. I was also puzzled by the underperformance of the rubber sector (think tyre suppliers) given that natural rubber prices had plunged over the previous six months. I suggested that this sector was surely worth a look. (For an explanation of why you should buy Bridgestone when the Chinese auto market is weak, see this post on natural rubber prices.)

What happened next: investors take refuge in defensives

From 29 February 2012 to 10 April the Topix market index (shaded in blue) fell by 2.7%, as the graphic below shows. What is interesting is that most of the high flyers of the bounce from November 2011 to the end of February 2012 have not continued their outperformance. The leaders of that period were, as we discussed above and showed in the graphic above, brokerages and related stocks, shipping stocks, auto stocks, iron & steel stocks and insurance plays. Since the end of February the Securities and Commodity sector has fallen 5.9%, Insurance is down 5.8% and Iron & Steel is down 9%. Marine Transport has fallen by 2.5% and Transport Equipment (autos) by 2.4%, so these two have managed some small outperformance. The worst performer of all was the Mining sector, down 9.5%. (Click on the graphic for a larger image.)

Japan Topix sector index performance (% change from start of period)

Meanwhile, the top of the table is dominated by defensive and domestic sector indices. Foods, retail, utilities, services and clothing make up the top 5. Pharmaceuticals and railways (Land Transport) come in 7th and 9th place respectively. Clearly there has been a rapid shift away from the more speculative or cyclical stocks and towards more staid plays. The rubber sector index fell by 2.3% over the period, so in absolute terms it has lost ground, although it did outperform Topix.

This strikes me as being healthy and I don’t think investors have abandoned cyclicals. It looks to me as if investors are rotating out of the higher beta sectors and into steadier stuff after the tremendous performance of the former sectors over the preceding four months. After taking a breather, what stocks will investors take a closer look at? My expectation is for investors to re-examine the main sector groups (including cyclicals) with a more critical eye, in an attempt to work out which have the genuine fundamental prospects that will fuel profit growth in the March 2013 financial year and beyond.

And so we come full circle to my conclusion: buy rubber stocks and auto parts stocks. For rubber, the driver is continued weakness in natural rubber prices, strong auto demand that will keep capacity for OEM tyres tight and prices buoyant and solid replacement demand in markets like the US (see this post on Japan tyre sales in March 2012 for more detail).

For the auto parts sector, the key issue is booming production at Toyota, which accounts for 30% to 90% of the revenues at the larger auto parts suppliers listed on Japan’s stock markets. I have already mentioned Denso, but Aisin Seiki is a favourite with domestic analysts and fund managers and would be a worthy alternative. In this post on auto sales I set out the arguments behind my positive view on autos. There’s also an interesting chart showing how Toyota’s global auto production will likely hit an all-time record high in March and April 2012.

Now, I am not well-informed on the market as a whole as I am a specialist in a small number of sectors. By all means if you can find other sectors with similar characteristics, pick a few stocks from those. After all, you can’t populate a portfolio solely with auto parts and tyre stocks – but I would definitely overweight them, even after the recent solid performance.

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