Buy Japan

When we revealed our new Trade of the Decade in The Daily Reckoning earlier this year, the reaction we got from a lot of readers could be summed up in one word: “Huh?” Almost no one quarreled with the first part of our trade, “Sell US Treasurys.” But almost no one agreed with the second half, “Buy Japanese stocks.”

From a contrarian standpoint, this negative reaction toward Japanese stocks warmed our hearts. Where has been the worst place to park your money for the last 20 years? What investment is so dull, so currently irrelevant, people don’t even talk about it anymore?

The answer: Japanese stocks.

In the early ’80s Japan Inc. was the marvel of the world. The Japanese had their technology, their management style, their strict adherence to national ethic and focused, organized capitalism. The stars seemed aligned for Japan. And they stayed that way for the decade.

The Nikkei 225 Index rose from 6,500 to nearly 40,000. Ivy league MBA programs were teaching a whole new set of buzzwords in Japanese, like “kaizen,” the concept of ongoing improvement. Americans even started to eat raw fish.

Throughout the ’80s, the Japanese bubble was inflated largely by credit, much like the US a few decades later. Stocks, bonds, real estate, art – even golf courses – became so desired that investors began borrowing money to have them.

Soon enough, most Japanese had to borrow to afford a stake in Japan Inc. When these asset classes, by sheer force of nature, began to correct, losses were exacerbated by countless loans going bad. Leverage, as the US would also learn later, works in both directions.

In the last days of 1989, the music stopped. The bubble went bust…and Japanese stocks tumbled into one of the most severe and enduring bear markets in modern finance.

Japan's Nekkei 225 Over 20 Years

The Nikkei fell as much as 80% from peak to trough and is still down more than 70% from its 1989 high! Sure, there were five sucker rallies along the way. They ranged from as little as 34% to as much as 136%. Each one lured spectators back into the water. And each one whisked most of them back out to sea.

Eerily like the US today, Japan sought to cure this problem with easy money. Interest rates were slashed to zero to bring the economy and the stock market back to “the good ol’ days.”

Japanese banks were pumped full of public funds to keep them afloat, but saddled with so much regulation they were labeled “zombies” of the industry, unable to thrive in any market condition. Because they were not forced to recognize and write off their bad debts, Japanese “zombie” banks have been reluctant to lend to anyone, especially to risky borrowers like new businesses.

The same Japanese who were the smartest, most innovative culture in the 1980s were often perceived as incompetents in the 1990s – incapable of adapting to change and repairing their damaged economy. To make matters worse, Japan had the oldest population in the world, with one in five citizens over 65…not the best foot soldiers for the battle against recession.

But today, you can buy Japan Inc. for almost the same price as when the whole mess first began – but that same price includes 30 years of innovation and (some) GDP growth. There are currently 200 companies on the Tokyo stock exchange selling for less than the cash held on their books, but hardly anyone is writing about it.

“Nobody is interested in Japan,” says Dr. Marc Faber. “All the funds have withdrawn money from Japan; they have given up on Japan.”

Corruption and crime is low. War seems unlikely. Incomes and employment have stabilized and the Japanese have returned to their thrifty, saving-oriented ways. Japan has a new government too, one that’s promised to reduce spending and bureaucracy.

Japanese government debt is very high, approaching 200% of Japan’s GDP. The interest rate on this debt cannot go up from its very low levels, or it might suffocate the economy. So the alternative would feature some form of money-printing like “quantitative easing” – i.e. buying government bonds with newly printed yen.

The Japanese government knows it is facing a tougher funding environment over the next decade. Many savers – the traditional buyers of Japanese government debt – will become spenders in retirement. That means these traditional buyers of government bonds will become sellers. Japan may need to attract international capital to keep refinancing its government debt. If its currency weakens over the next few years, by the middle of the decade, international investors will be more enticed to buy yen and yen-denominated government bonds.

When the currency of a manufacturer’s home country weakens, and it is selling products into markets with stronger currencies, the effect on profit margins can be dramatically positive. So world-class, export-oriented manufacturing companies based in Japan could lead Japanese stocks higher.

Could things in Japan get worse yet? Maybe over the next couple of years… but they’ve been beaten down for so long, it’s hard to imagine much worse. Many investors have given up hope, which has pushed valuations to low levels. We’d rather bet on Japanese stocks over the next decade than against them.

All the same, we’re not going to put our eggs in one basket. That’s why we have two fund recommendations to take advantage of the world’s most-hated asset class.

First is the iShares MSCI Japan Index Fund (NYSE:EWJ). It mirrors the performance of the MSCI Japan Index, a very broad swath of Japan’s largest companies. And it gives you a good shot at outperforming the benchmark Nikkei 225 Index. On both a one-year and a five-year basis, EWJ has beaten the Nikkei.

But don’t limit yourself to the blue chips. In almost every market turnaround, small-cap companies lead the way. So pick up the Fidelity Japan Smaller Companies Fund (FJSCX) as a supplement. This fund outperformed the MSCI Japan Index during the post-rebound in 2009. And it might do so again when Japan really starts to rebuild. Plus, you’ll gain exposure to many companies in this fund that you won’t find in EWJ.

Remember, this is the Trade of the Decade. Not the Trade of the Week. Buying gold in early 2000 at $300 didn’t look like a very smart move in the summer of 2001, when it was $260. Patience counts.

Addison Wiggin
for The Daily Reckoning

The Daily Reckoning