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Nejat Seyhun
  Nejat Seyhun

Is There a Profit Opportunity in Japanese Stock Markets?

3/24/2011 --

Like Warren Buffett, Ross finance professor Nejat Seyhun says don't bet against it.

Recent events in Japan and the rest of the world have been nothing less than extraordinary. Triple disasters in Japan: the massive earthquake, tsunami and the nuclear crisis combined with radioactive fallout have combined to bring down the Nikkei 225 index by about 10 percent between March 11 and March 24, wiping out over $300 billion of value from the Nikkei index.

Over the last weekend, the United States and her European allies have started an intense bombing campaign in Libya, which cut off more than 75 percent of Libyan oil production of 1.6 million barrels a day. Meanwhile, Saudi military has entered Bahrain to provide support to the ruling El-Khalifah family there. The loss of Libyan oil combined with possible additional future supply shocks have pushed the front-end contract for Brent crude on ICE to $115, up about 15 percent over the past month or so.

In the midst of all this chaos and loss of confidence, Warren Buffett declared on March 21 that Japan's "record earthquake created a buying opportunity for equity investors." Buffet stated: "If I owned Japanese stocks, I would certainly not be selling them because of the events of the past 10 days or so. Something out of the blue like this, an extraordinary event, really creates a buying opportunity." This is an amazing vote of confidence on Japan. Why is Buffett so optimistic on Japan's prospects, especially when the Japanese index is currently less than one-fourth the level it attained more than 20 years ago?

One view is that since Buffett has a bullish derivative bet on Nikkei 225, he would prefer to see the Nikkei index rise from its currently low levels. "Berkshire would owe $3.8 billion to derivatives counterparties if index prices and foreign exchange rates at maturity were unchanged from the levels of Dec. 31," Buffett said last month in his annual shareholders' letter. Thus, anyone buying Japanese equities will be helping out Buffett and his shareholders in Berkshire Hathaway.

An alternative view is that Buffett is genuinely sanguine about Japan and sudden disasters, and possible market overreactions to them can create unique buying opportunities for those investors who have the risk appetite. How does one reconcile these diverging views of the Japanese stock markets? Is there any historical evidence that bears on this issue?

My own research into the record stock market crash in the United States Oct. 19, 1987, uncovered evidence that the top corporate insiders believed that the 22.6 percent decline for the Dow Jones Industrial Average represented an overreaction. Top corporate insiders bought stocks in record numbers the very next day on Oct. 20. Moreover, stocks purchased by corporate insiders between Oct. 20 and Oct. 31 also bounced back the most over the next 14 months. Clearly, corporate insiders immediately identified stocks that were oversold in the panic and purchased them in record numbers.

Looking back at the Kobe earthquake in January 1995 also indicates a sharp decline followed by a sharp bounce-back in the Nikkei index. In reaction to the massive Kobe earthquake, the Nikkei index declined by 8 percent, followed by a 6 percent immediate bounce-back. It then continued to decline by about 24 percent between January and June 1995. Finally, the Nikkei index proceeded to bounce back to pre-earthquake levels by the end of that year.

In general, the finance literature shows that sudden large declines in the stock markets are often reversed to a large degree. In his book "Irrational Exuberance," Robert Shiller shows that for the 25 largest one-year stock market declines in international stock markets, 18 of the countries (representing 72 percent of the sample) exhibited large bounce-backs over the next year. The initial one-year declines for the 25 countries averaged 56.1 percent. The subsequent one-year returns for the same 25 countries averaged 36.3 percent. Hence, almost 65 percent of the initial reaction is subsequently reversed. This evidence is also consistent with the conclusion that substantial overreaction played a role in historical large stock market declines.

Overall, it is impossible to tell what the next year will bring for Japanese stock markets. History, however, seems to be on Warren Buffett's side. Once again, it seems like a good idea not to pick an argument with the "Oracle of Omaha."

For more information, contact:
Bernie DeGroat, (734) 647-1847,