Japan's Stock Market Should Climb, But Will It?

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By Martin Hutchinson
Contributing Editor

When Japan reported its fourth-quarter growth numbers yesterday (Thursday), it surprised everyone by announcing that gross domestic product (GDP) advanced at a 3.7% annual clip – really damn good when you consider the country has no population growth at all.

Meanwhile, the United States posted quarterly growth of only 0.6%. Given the difference between the two economies – and the ever-spreading debt crisis in the United States – why did Tokyo's Nikkei 225 Stock Index dropped 23% over the past year, while the Standard & Poor's 500 Index is down only 7% during the same period?

Japan's reality is genuinely bright, after a dreadful near-recession that lasted close to 15 years. The economy is growing at a decent clip, the balance of payments is in surplus, the yen is strong and the government budget deficit, which had been too high for too long, has dropped to 4.5% of GDP in the 2008-09 fiscal year. That's the lowest since 1997. [For a related story on Japan's surprise GDP report in today's issue of Money Morning, please click here].

Productivity has generally grown faster than in the United States, which indicates that the competitiveness of Japanese companies should steadily increase against their U.S. rivals over the long haul [Do I even need to cite the competitive differences between Toyota Motor Corp. (TM) and General Motors Corp. (GM)? I think not].

Then we come to the Japanese stock market – or, Money Map Report subscribers who have followed my recommendations for Japanese shares are doubtless now calling it, the expletive-deleted stock market [The Money Map Report is a sister publication to Money Morning].

Japan's stock market is down more than two thirds from its all time high, which was set in January 1990. Think about that: Children born after the Nikkei peaked have been voting in the U.S. primaries this year!

The Nikkei had appeared to recover along with the economy over the last few years, but then last spring it began to slip, and the decline Wall Street has experienced since October helped transform that mild slip into a full-fledged tumble. If Japan's economy is so solid, why is its stock market dropping?

As a chastened recommender of Japanese shares, I have a theory. Traders tend to hold their beliefs about the world from their long-term experience, and that of the older traders who introduced them into the business. Even when the world changes, trader psychology doesn't, so these traders soldier on with their old beliefs long after they have ceased to be valid.

Think that's psychological hooey? Believe in the Efficient Market Hypothesis, which tells you that all information available to the market is priced rationally into stocks, so that market prices reflect true prospects for economic conditions and corporate earnings?

Well, maybe yes, maybe no, but answer me one question: After the subprime mortgage crisis really hit at the beginning of August, and it became obvious that banks were going to have to suffer huge losses, and that the U.S. housing-finance market would never be the same again, in which direction did the U.S. stock market head?

It went up.

I know it's a totally, unbelievably irrational reaction, but it happened. On Aug.1, the Dow Jones Industrial Average was at 13,362 and the Standard & Poor's 500 Index was at 1,363. On Oct. 9, slightly more than two months later, the Dow closed at 14,164 and the S&P 500 closed at 1,463.

Thus, in the two months that saw the beginning of the biggest financial crisis in at least 25 years the Dow rose about 6% and the S&P 500 rose about 7%. Prospects for U.S. economic growth deteriorated, prospects for earnings were decimated – at least in the financial-services and real-estate sectors – but the market persuaded itself that the value of stocks as a whole had increased.

PhD theses will be written for the next 50 years on what really happened in August 2007. However, it's my belief that the market surges were caused by traders who simply refused to believe that the great tottering tower of the U.S. debt market could ever topple, and assuming that all would be made well by U.S. Federal Reserve Chairman Ben S. Bernanke lowering interest rates yet again, which, in turn, would fuel further increases in U.S. economic output.

Life in the financial sector had been so good for so long – well over 20 years, with only a few short hiccups – that nobody could believe it would ever end.

Similarly in Japan, even though the Japanese economy has now been growing steadily for five years, and state finances have considerably improved and are continuing to do so, nobody can believe that the economy isn't about to fall back into a deep recession. When U.S. subprime mortgages went wrong, the first reaction of Japanese traders was that the United States would easily surmount the problem, but Japan was in deep trouble.

You can see the same effect currently in Germany. For 40 years – from 1950 to 1990 – West Germany had excellent growth, so when East Germany and West Germany merged in 1990, everybody believed that any problems would be quickly solved. Only when a huge real estate crash hit in the late 1990s did traders turn negative on Germany, at which point they decided that the economic growth of the postwar years had been succeeded by a massive failure of the German economic system, which would never show decent growth again.

Well, what do you know? In the last few years, Germany has shown much better growth, and its labor competitiveness is now by far the best in the Eurozone. It turns out that the costs of integrating East Germany were huge, but also transient, so that now, nearly 20 years after the merger, the costs are declining and Germany is resuming its traditional place as the strongest economy in Europe.

I hesitate to recommend Japanese shares. After all, they have done so badly for those who bought them last year. Nevertheless, at 13,000, the Japanese stock market is now decidedly cheap, and Japan – especially its domestically oriented companies – appears well insulated from any problems arising from a U.S. recession and associated debt crash.

At some point, traders will finally understand that Japan has resumed its traditional position as one of the world's best economies, and Japanese shares will be sharply re-rated. Probably that will happen once markets in the United States and other housing-crash countries such as Britain and Spain have finally bottomed – a sharp rise in Tokyo will be the first sign that the global slowdown and pain has finally ended.

So, with the caution that it could still be too early to buy, and irrational pessimism about Japan may continue for a while yet, I would suggest looking at the SPDR Russell/Nomura Japanese smaller companies exchange-traded fund (JSC), down 30% in the last year but surely due for a turn; at the fuzzy logic control systems manufacturer Omron Corp., quoted only on the Pink Sheets (OTC: OMRNY) which has rising earnings and a Price/Earnings ratio of less than 12; and the video-game manufacturer Konami Corp. (KNM), which is benefiting greatly from the new Playstation 3 and Wii video game consoles.

Sometimes [but, alas, not always], it pays to buck the trend. Let's hope that this is one of those times.

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