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No fund manager who fancies their job will look at Japanese stocks, yet this may well prove to be the best opportunity in modern history to invest in the Japanese stock market. Since the start of last year, we have seen:

  • One of the worst natural disasters on record hit Japan, where for about 10 days the country was shut down.
  • The yen trades at an all time high against the USD and multi-month highs against a number of other currencies.
  • Financial markets have been battered by the ongoing euro debt crisis, where volatility reached unprecedented levels.

You would think that the average Japanese stock would be trading materially lower than where it was at the start of 2011, but this isn't the case. In fact at the time of writing, most Japanese stocks are more or less unchanged on levels they were trading at the start of 2011. I'm using Japanese Small Caps as a proxy for the average listed Japanese stock.

TSE Small Cap Index

So if all the events of 2011 were not capable of pushing Japanese equities lower, what will? Could I go so far to say that the Japanese equity market has reached rock bottom and that investing in Japanese equities is one of the least risky trades for the next 5 years?

It isn't hard to justify how cheap Japanese equities are. I'll try and keep my analysis simple and use just one valuation metric - the price to book ratio, I could use other metrics but these all tell the same story. The average Japanese stock has a price to book ratio of about 0.83x. Just a few weeks ago they were trading at a P/Book ratio of 0.65x. This is more or less as low or as cheap as they were during the worst of the Global Financial Crisis!

Price to Book Ratio of the TSE Small Cap Index

What about earnings? Popular opinion would have it that the earnings outlook for the average listed Japanese stock is rather dismal and that it probably hasn't recovered significantly from the GFC some three years ago. In the case of a few large cap Japanese stocks, this is certainly the case, thanks in large part to the strength of the JPY. But beneath the scenes a very different story emerges. Earnings of the average Japanese stock are not too far away from multi-year highs. You might not think that this is a big deal but given the economic headwinds that the average Japanese stock has faced over the last couple of years - this is nothing short of a miracle! One can only but wonder how high Japanese stocks would go if instead of encountering these headwinds over the coming months the reverse happened and they became a tail-wind for Japanese stocks.

Earnings of the TSE Small Cap Index

From a technical perspective, something very bullish is brewing in the Japanese equity market. For over three years the average Japanese stock has traded in a tight trading range. Perhaps if it weren't for the Fukushima crisis they would already be trading at multi-month highs.

However, Fukushima is now history and the average Japanese stock is within a few percent of trading at a 3.5 year high. This time I think the breakout will occur. Given that the trading range has been rather tight for such a long period of time, when the breakout happens it is liable to surprise even the most optimistic bulls (if there are any).

TSE Small Cap Index

But why should it be different this time around? Why should we expect material upside in Japanese equities? Well it comes down to this: for whatever bizarre reason the two perennial enemies of the Japanese stock market, the Yen and Japanese government bonds (JGBs), have been seen as a safe-haven by investors. Taking fright over the dramatization of the Euro debt crisis investors have flocked into the perceived safety of the JPY and JGBs, such that the "safe-haven" trade (long JGBs and the yen) has become one of the most crowded trades on the planet. The overcrowding in the Yen and JGBs has pushed the US Dollar and Euro to multi-year lows against the Yen, and the same for yields on JGBs.

USD/JPY Spot

Yields on JGB 10yr

Irrespective of how attractive fundamentals are or aren't for a market, if a market is widely held by investors (just like "TMT" stocks were at the height of the bubble in late 1999/early 2000) then it no longer becomes "safe." Crashes are associated with markets that are widely held. But foreigners aren't the only holders of JGBs they are widely held by Japanese nationals through one form or another.

This isn't anything new, however, we now have a situation where this is the most widely held that JGBs have been by Japanese nationals in about 20 years and the most underweight they have been the Japanese stock market. Stocks as far as the Japanese are concerned are a very bad joke.

Given the magnitude of the crowding into the yen and JGBs it is difficult to imagine that we will see any significant upside in these markets over the coming months. Accordingly these two markets should not present headwinds to Japanese equities anymore. Perhaps they may well provide a "turbo boost" if they start to breakdown, which appears to be the case in the Yen already. So I see little downside and substantial upside in Japanese equities. Position yourselves for the next big wave.

Source: Japanese Equities Will Surprise Even The Biggest Optimists