Are Value Stocks and Defensives the Only Place to Be?

By Darrel Whitten

Surveys indicate that global investors are becoming increasingly anxious about inflation, and what this means for interest rates and monetary policy. Monetary policy around the globe (beginning with the FED’s policy) is seen as too sanguine on inflation, and investors fear that central bankers are falling behind the inflationary curve–implying that when central banks do move, they will have to tighten monetary policy more aggressively than if they had moved sooner. The fear is that there will be a repeat of 1994, when the FED raised rates in rapid succession and caused a correction in the stock market.

Consequently, these same global investors are becoming significantly more risk adverse, and are adopting more defensive portfolio allocations. The majority of these investors apparently remain overweight Japan, although this weighting may also be at risk if risk aversion progresses further.

The US “rate hike syndrome” has already caused the US NASDAQ to drop below its 200-day moving average, indicating that the current correction will be more prolonged. While watching the NASDAQ, some Japanese investors pay more attention to the Philadelphia SOX semiconductor index in terms of its influence on the Japanese market. At this juncture, the Philly SOX is in even worse shape than the NASDAQ. So much, in fact, it has recently rallied from an oversold position.

Japanese semi majors such as Advantest and Tokyo Electron have generally not participated in all but the early stages of the 60% rally seen in the Japanese market, and moreover have ignored their return to profitability. Tokyo Electron, Japan's largest semiconductor and liquid crystal display making equipment firm, booked an Y8.30 billion group net profit for FY2003 to March, 2004, reversing its year-earlier loss of Y41.55 billion. Brisk sales of chip-making tools to Japanese and other Asian semiconductor and display manufacturers lifted its group sales to Y529.65 billion, up 15% from Y460.58 billion a year earlier.

The company's group operating profit for the year rose to Y22.28 billion, up from Y1.12 billion a year earlier. In addition, for the January-March quarter, TEL’s orders outstanding nearly Y262.3 billion, up about 90% from Y138.3 billion for the three months to March 2003. Orders in its electronic components unit also rose 29% on year to Y8.7 billion during the quarter. Chip-making equipment sales were particularly strong in Japan, Europe and Taiwan, and combined semiconductor-making equipment sales in the three regions stood at 65% of the firm's group sales. Conversely, full-year chip-making equipment sales in the U.S., which accounts for 12% of total group sales, fell by 32% to Y50.6 billion. Moreover, for the current year to March 2005, the company is forecasting its group net profit to surge more than six times to Y52.0 billion, on sales of Y630.0 billion, up 18.9% YoY. According to Tokyo Electron, appetite for capital investment among global semiconductor makers is recovering rapidly and it expects more demand for its products this fiscal year.

This notwithstanding, Tokyo Electron’s stock has been falling since September of last year. It appears that analysts and investors generally expect a peaking-out of the upward phase of this silicon cycle in 2005. US market researcher VLSI predicts that Q2 2004 revenues will in fact decline for tool vendors following the end of the Japanese fiscal year and buying cycle. If not, the semi equipment industry is in danger of repeating the boom/bust cycle of 2000, achieving two years' worth of growth in one, VLSI warns – a scenario its analysts have been worried about for the past several months. The favorable April B:B ratio followed seven consecutive months of B:B ratios above parity. Meanwhile fab capacity utilization rates were down from March's level of 88.5 percent to 87 percent. Indeed, some semiconductor analysts are warning of a peak in the silicon cycle as early as next month (June).

But PC demand, historically a major driver for semiconductor demand, is in the midst of a major replacement cycle. According to Gartner, nearly 100 million PCs are likely to be replaced this year, with 120 million being swapped out in 2005. The volume of replacements in the next two years will surpass the number of units replaced in the run-up to Y2K in 1998 and 1999, Gartner said. In 2004, replacement units will drive global shipments to 186.4 million - an increase of 13.6 per cent over 2003.

Partially reflecting this, worldwide semiconductor equipment revenues grew 24 percent to $11.9 billion in Q1, following sequential increases of 16 percent in Q3 of 2003 and 14 percent in Q4, according to VLSI Research. Indeed, if replacement demand for PCs is as large as Gartner foresees, this demand will come on top of already diversifying demand for semiconductors from mobile phones, digital consumer electronics, and flat panel displays–and it will diffuse through the semiconductor industry, helping to support what the bears insist is the beginnings of the bust portion of the silicon cycle.

In Japan Late-Cycle, Domestic and Defensive Sectors Have Been Leading

Reflecting increasing risk aversion by investors, late-cycle, defensive sectors have so far led 2004's performance, despite strong upward estimate revisions in profits and evidence that the economy is in the early stages of recovery and therefore is surprising on the upside, both in the US and Japan.

Indeed, that is the hidden message behind the recent hard line stance the auditors and the FSA (Financial Services Agency) have taken regarding UFJ Holdings and the pressure they are now under to clean up their loan books–i.e., what the FSA is saying to the banks is “reduce your non-performing loans to levels required by 2005, and de-link your balance sheets from the stock market so that Japanese interest rates can normalize”. On the other hand, the BOJ is not about to back off of ZIRP prematurely, which means that when they do, they will be fully confident that Japan’s economy and financial sector can handle it.

Yet the consensus of the major domestic think tanks for Japan’s GDP growth in 2004 is 3.2%, with 1.6% growth foreseen in 2005. Behind such estimates is the assumption that Japan’s business cycle will be peaking over the next six months. But if Japan’s global competitiveness is indeed recovering, what happens with earnings and the impact this will have on stock prices is many times more powerful than the short-term psychological impact of an eventual abandonment of Japan’s zero-interest rate policy, or ZIRP.

Moreover, if investors are really worried about inflation and rising interest rates, growth stocks at some point deserve another look Historically, growth stocks outperform value stocks as interest rates rise - as they are now. That could happen again in this cycle, particularly as Japan’s economy enters a secular recovery that would overlay a peaking of the current business cycle.

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Associate Editor: Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Robert Windorf, Sergei Blagov, Darrel Whitten and Jonathan Hopfner

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