Why are equity investors talking about Japan?

Investors who are worried that a decade-long bull market could be coming to an end point to a key chart in Japan that has signalled trouble in the past. But are they right to be concerned?

The cyclical/defensive trade-off

When building a portfolio, investors usually try to blend cyclical and defensive stocks depending on their view of the economy;

I recap the key difference between these two types of stock below. The key concern for some observers is that defensives may be starting gain momentum and this may be a sign of trouble ahead, not just in Japan but more widely.

A quick refresher

Cyclical stocks are the ones that tend to outperform when the global economy is doing well. Defensives, on the other hand, are the kind of companies that sell products that are needed in good or bad times – as such they are less connected to the ups and downs of the economic cycle.

The chart the bears are worried about

So far, so what? Some investors believe that the balance between the two types of stock reveals much about how investors see the economic cycle playing out.

·         When investors are confident they will tend to favour cyclicals over defensives

·         When investors are growing nervous they will favour defensives over cyclicals

It is the latter that some observers say we are starting to see in Japan;

Here you can see that having risen for some time, this line that shows the balance of cyclicals versus defensives within portfolios, has started to dip. This, say the bears, is important. But is it?

A quick look at other markets

So far, the change does seem to be limited to Japan as the following two charts reveal. They show that investors in the US and Europe are still happy enough to hold cyclical stocks, as they have been for some time.

Conclusions

As ever in investing, there are two sides to every story revealed by a chart. Yes, a dip in the cyclical/defensive ratio has been a lead indicator in the past, most notably in 2007. However, it has also been a red herring in the more recent past. Right now therefore it probably falls into the category of “watch and wait” – the change in the Japanese chart is interesting but for now, given it is occurring in isolation and over a relatively short time frame, it may not be much more than that just yet for global investors.