As we ponder over the possibility of a nuclear nightmare in Japan, global stock markets staged a rebound after two days of losses. Is this the start of a V-shaped rebound?

The heavy and indiscriminate selling over the past 2 days was pretty much a knee-jerk reaction to a nuclear catastrophe scare on top of the negative shocks to demand and supply chains that the earthquake and tsunami have wrought. From the peak in February, the Nikkei index plummeted more than 20% as of Tuesday.

If it were just the earthquake and tsunami, then a fall of such magnitude would have presented a buying opportunity as Japan will eventually recover as a society and as an economy as tragic as the events have been. Just for perspective, the Nikkei fell after the Great Hanshin earthquake of 17 January 1995 by about 25% over a period of 5-6 months. It can be argued that the bottoming process then was compounded by an over-valued market and prolonged by the collapse of Barings in the UK.

However, the nuclear disaster brewing now is the wild card. We are in essence dealing with a binary event – either a nuclear meltdown or no meltdown. In this binary bet, you buy if you believe in the no meltdown scenario and sell if you agree. With the nuclear situation still fluid with both positive and negative news flows, we see the 5.7% rebound in the Nikkei today as largely short covering, although there are surely some investors taking the binary bet.

The worry is not about the quantifiable impact of the natural disasters on the economy and industries. The fear is of the unknown and the unquantifiable implications of the current nuclear fallout which could range from controllable radiation leaks with minimal implications on the local and global economy to a level 7 nuclear disaster of the magnitude of Chernobyl. And Japan is not Chernobyl. It is the third largest economy in the world and accounts for a fair bit of the global supply chain especially in high value added technology.

No, we are not about to make the binary bet. This is not like making a call on interest rates or a currency bet. Official statements do not help as they are usually less upfront. But from what I’ve been reading about the Fukushima nuclear reactors, a complete meltdown seems unlikely. Still, we keep a watchful eye on the developing situation and we’ll use technical indicators to guide us in any entry levels. We will keep you posted.

Patience...

Japan’s nuclear crisis deepened today as the third blast at the Fukushima Daiichi Nuclear Power Station forced the evacuation of emergency workers and the Prime Minister Naoto Kan to warn of a clear possibility of nuclear radiation leaks. Markets took a turn for the worse on news of elevated radiation readings in Tokyo, pushing the Topix index to its worst two-day plunge since 1987 and dragging other major stock markets along with it.

As we know, markets do not like uncertainty. At this point of writing, there is still much confusion as to the real status of the nuclear fallout. Given that, we expect the markets to trade on news flows with a bias to exaggerating the risks. We feel there is further downside risk in the near term but it is not easy to quantify. The best strategy as always is to remain well diversified.

We feel there are opportunities to invest in this crisis – in coal, oil and gas as well as construction and building materials companies – but now we need some patience. We will keep you updated on further action.

Japan crisis...

The triple crisis in Japan – earthquake, tsunami and nuclear – will have a negative impact on global growth in the short term. The scope of the damage is yet to be assessed but will likely exceed the 20 trillion yen in damage sustained during the Kobe earthquake in 1995.


The chart below shows the Topix index performance after the 1995 earthquake. The index fell by 21% and bottomed 5 months later before rebounding to pre-earthquake levels only 11 months after the earthquake. During this period, construction, real estate and medical product industries outperformed while insurers, high-tech and cyclical sectors underperformed. Power companies stocks did well the last time. But with the nuclear crisis brewing, they are unlikely to repeat the positive performance.

Going by the previous experience, it may be too early to participate in any reconstruction recovery. Opportunities may be found in the construction sector. But with rolling power blackouts, it remains to be seen how industries will be impacted in the coming months. After all, Japan relies on nuclear power for one-third of its electricity needs.

The JPY was well-supported in the last earthquake. But with massive liquidity injection of 15 trillion yen by the Bank of Japan, the yen has started to erase earlier gains. The repatriation of yen by Japanese companies and investors in the coming weeks should support the yen at current levels.

Meanwhile, the near term market outlook remains mixed with the focus on Japan and the Middle East crisis. I remain optimistic in the global outlook and would become more aggressive on the buy side at lower levels.

 * Chart from Citi Investment Research