Article by John Authers of the Financial Times

In wake of disaster, some follow the money

By John Authers

Published: March 18 2011 22:58 | Last updated: March 18 2011 22:58

There has seldom been a better time to test one of investing’s oldest dicta: that you should buy when there’s blood in the streets.

After the earthquake, tsunami and nuclear emergency in Japan, and countless tales of tragedy, there is an opportunity to do precisely that. But is it such a good idea to invest when others are suffering, and more specifically, is there an opportunity to buy Japan now?

If the saying just means buy when prices are lowest, then it is a truism and leaves open the question of how to work out when prices have truly bottomed.

However, it speaks to a deeper truth, that, as humans, we are affected by visible human suffering, and that this clouds our judgment. It is therefore plausible that the market might predictably overreact to events with a high human cost and assume that the economic cost is also high. That proposition has some truth to it.

Garry Evans, of HSBC, researched stock market reactions to catastrophes that were to some extent similar to last week’s Japanese disaster: the Kobe earthquake of 1995; the terrorist attacks of 2001; last year’s Chilean earthquake; and the Taiwan earthquake of 1999.

In each case, the local stock market fell between 6 and 8 per cent in the days after the disaster and remained weak and volatile for about a month. But it resumed its pre-catastrophe level in between 23 and 78 days, after which the factors that had preoccupied the market before the disaster took over. A hundred days after disaster, the affected market was always up and in one case by almost a third relative to its pre-disaster level. So disasters do, it seems, present buying opportunities.

But that is just the stock market. This disaster also hit the currency market, leading on Friday to the first co-ordinated currency intervention by central banks in more than a decade. Counter-intuitively, the earthquake caused the yen to strengthen against the dollar as traders worked on the assumption that Japanese savers (who mostly have their money stashed overseas) would have to bring money home, while international insurance groups would have to make big pay-outs in Japan – which would mean selling dollars and buying yen.

Before central banks intervened, the yen gained 8 per cent against the dollar – salving the pain of the fall in Japanese stocks for international investors but also opening any bargain-hunters to a nasty loss when and if the yen returns to previous levels.

The experience of Kobe, which also required big insurance pay-outs, is instructive. The stock market had serious losses in yen terms but, as the chart shows, a surge in the yen virtually cancelled them out for international investors within three months. This time around, the forex market seems to be ahead of itself and working on the assumption that those repatriation flows are a certainty.

So international investors should not buy when there is blood in the streets without thinking of the counterbalance that often comes from foreign exchange.

A final question remains. There is a predictable immediate psychological response to a catastrophe but those who seek to profit long-term want to buy assets when they are truly cheap. Does that apply to Japan today?

Japan’s litany of problems is well known. Its economy has stagnated for two decades, there is no room for stimulation from easier money, the government has the developed world’s most serious deficit and its population is ageing, suggesting that things are destined to get worse. If you want to live in a country enjoying fast economic growth, you might do better than move to Japan. But none of this precludes the chance that the market is pricing Japan’s stocks too cheaply.

If we assess value relative to other countries, Japan has been cheap for ages and looks infeasibly so. Judged as a multiple of book value (assets minus liabilities on their balance sheets) Japanese companies are half as expensive as US companies.

Judged by cyclical price/earnings multiples (comparing share prices to the average earnings over the past 10 years), Dylan Grice of Société Générale shows Japanese stocks, at a multiple of 16 for the Topix index, are as cheap as they have been since the late 1960s. (Adjusting for inflation, they were slightly cheaper in 1978.)

Doubtless there are caveats. Disasters can have political effects. In recent history, for example, President George W. Bush never regained his political capital after hurricane Katrina. So there is a layer of uncertainty there. The nuclear incident adds a toxic layer of uncertainty that was not present after Kobe (although, by the same token, neither the Three Mile Island nor the Chernobyl nuclear accidents had any discernible impact on stock markets). In this case, it does look as though the old dictum is right. A predictable psychological response to a disaster has turned an already cheap market into a compelling buying opportunity.