We have commented more than once (most recently in our August 27 Seeking Alpha article) that Japan's demographic picture has been dreadful since its Consumer Spending Cycle peaked in the late 1980s (1948 peak births plus 40 years).

The country does have a demographic "window of opportunity" from 2002 to 2014, (please refer to the Japanese birth chart on page 17 in our January 2009 Report) when its Consumer Spending Cycle picks up short term before turning down again sharply in 2014 until around 2050.

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (August 17th):

The following graph highlights our proprietary short-term technical indicator displayed with a chart of the Dow Industrials. You can see that it has done a very good job of identifying the March and July lows and turned bearish in June as the market was attempting a breakout through 950. It is now at a severe negative reading and this is why I am in a maximum defensive position. With the frenzied pace of buying that we've seen in the markets we could see an air pocket develop over the next several weeks. Caution and patience are recommended at this time.

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, published Monday (July 27th):

Last Friday, a Capitol Hill insider sent me the nearby schematic of the proposed Obama healthcare plan. According to her, said schematic is trying to be repressed for obvious reasons. As I sat there, attempting to decipher it, I was reminded of a similar schematic I used in a report titled “Crystal Clear?!” back in 1993. At the time “Hillarycare” was in full regale and equally complex.

In many ways, the U.S. recession of 2008-2009 resembles Japan’s own economic debacle in the 90s and beyond. An overly confident national mood, appreciating asset prices, coupled with a ballooning real estate market and a heavily indebted corporate sector were the triggers of the long slump and the decades long bear market in Japan in the 90s. A look at the long-term chart of the Nikkei is a good indication of how bad it could get for the world and the US in the coming years. Rallies that lasted for years, declarations of bull markets did not manage to color the pale picture of the underlying bear market which has been ongoing for about two decades.

Is Japan in any better shape in this crisis? Yes and no. Japan’s corporate culture, and its sense of invincibility had a severe beating and a reality check once the bubble of the 80s burst. But as usual in a capitalist system, this has also allowed Japanese firms to adopt some aspects of the ruthless Western style of management, ensuring a more dynamic environment where the principle of survival of the fittest is applied with greater vigor.

With all of the furor over the past quarter, I did not update my actions on my portfolio. Today I do so.

New Buys

At the beginning of each calendar year, I sit down and see how my expenses have tracked over the past year. I make a table and a pie chart to show my wife. She is always amazed at how much goes to taxes, though the new amazement is what it takes to put children through college. We spend some time discussing plans for the next year. Since my wife is not money-oriented (not a big spender, and focused on teaching the children) this gives her a quick way to get reoriented in our financial situation.

After that, I look at investment income. 2008 was an unusual year for me in this way: it was the first year in my working life that my net worth fell. Though painful, at age 48, I’m grateful that I have had a good past.

The Japanese government conceded yesterday that Japan's longest running postwar period of economic expansion might now be over as it reported a drop in its key measure of underlying economic conditions for June. The June coincident indicators index fell a preliminary 1.6 per cent and the government downgraded its assessment of the economy to "deteriorating." This effectively constituted an admission that the economy had probably entered a recession.

The coincident index, a composite of statistics including production and the ratio of jobs to applicants, fell to 101.7 in June from 103.3 a month earlier. A three-month moving-average of the index fell for a fourth month in June to 102.2 from 102.5.

Japan is still hanging on it seems, but for how long? This is what I will try to clarify in this entry. In the following I will thus continue my ongoing analysis on two months' worth of data as well as loads of timely analysis from other sources where, as usual, Ken Worsley and Takehiro Sato/Feldman from Morgan Stanley have my complete attention. In accordance with tradition four overall themes will form the backbone of the analysis; trends in prices, domestic demand figures, industrial output/exports, and finally the JPY which as ever is the subject of much attention in currency markets and beyond.

When it comes to prices it could seem as if Japan's quick return to inflation in the core-of-core index was nothing more than a blip. As can consequently be observed from the graph below Japan is once again stuck in deflation measured by the core index stripped of energy and food input; both April and May thus saw a decline in US style core prices of -0.1%.

At present I own a position in the Japan Smaller Capitalization Fund (JOF).  One of the things that I talk less about in my investing, is my willingness to allow some professionals closer to the situation manage a small amount of the assets, if they have a good track record, and the area of the global markets is deeply out of favor.  When I do this, it is typically for just one investment, and not more than 5% of the total portfolio.

Japanese small caps?  Definitely out of favor.  When I look at the top ten holdings of the Japan Smaller Capitalization Fund, I can justify holding them on a book value basis, and on an earnings basis, relative to the low interest rates in Japan, they make sense as well.

The Fed has pulled out all the stops to get its arms around a massive credit crisis. Most importantly, they have opened the Fed’s discount window to securities firms for the first time since the Depression, while the government has relaxed the capital rules for Freddie Mac and Fannie Mae, ostensibly to put a prop under the collapsing US mortgage market.

The Japanese credit market is a colossal local affair, and has traditionally performed independently of U.S. and European markets, reports PIMCO's Koyo Ozeki. However this trend has begun to reverse, and the implications of this could be significant for Japan:

Japanese corporate bond markets offer the cheapest means in the world at present for issuers to raise money, and we expect the volume of bond issuance to increase going forward, including a shift from stocks to bonds as the fund procurement method. This, along with the increasing popularity of samurai bonds by U.S. and European banks and Asian issuers, could cause the balance in corporate bond markets to swing from excessive demand to oversupply within the next six to twelve months.

I ended up doing more in the first quarter reshaping than I had originally intended. Here are the trades:

New Buys

Has Japan become a museum piece? Is the Japanese economic experience to serve only as an historical lesson to others, as it slips off the international investors' agenda? These were some of the questions asked at Macro Vision, Morgan Stanley’s annual conference in New York on the global macroeconomic outlook, as reported by Robert Alan Feldman in Morgan Stanley's Global Economic Forum.

At the conference, a similarity was drawn between Japan's financial meltdown and the current U.S. subprime debacle: "imprudent borrowers, imprudent lenders, [inadequate disclosure] and unprepared regulators." In contrast, though, the strengths in the U.S. - the rapid response of institutions, the deeper markets, and regulator scrutiny - have led many investors to conclude that the U.S. will not repeat the lost decade of recovery that Japan has experienced.

There were some winners, with the top-5 performers all posting double-digit gains, led by Mitsui & Co.'s (MITSY) 42% return. Rounding out the top five were: Makita (MKTAY) +35%, Sony (SNE) +27%, Hitachi (HIT) +17% and Internet Initiative Japan (IIJI) +17%.

Some (rare) macro investment thinking I've been doing lately has lead me to Japan. In a post earlier this week I highlighted how Japan is certainly below average when looking at the world markets from a profitability perspective. I will be the first to concede that low profitability may be a non-intuitive place to unearth investment ideas, but in the case of Japan, there may be something interesting lurking underneath the ugly numbers.

Japan has a couple of issues which I believe have really compressed corporate profitability:

Meanwhile, the US economy is generally expected to continue slowing, at least through Q1 of 2008, and recent quarterly profit growth has turned negative?i.e., we are seeing the development of a classic stagflation scenario?waning economic growth with accelerating inflation.

Over the last few months, it has been a popular trade among Asian hedge funds to short Japanese stocks and go long Hong Kong and China. It's been a very profitable trade for these funds, but its looking pretty crowded, so once it unwinds you could see some sharp moves on the upside for Japan. These hedge funds have been selling to accumulate cash ahead of their book-closings at the end of the year, and many analysts suggest that most of this selling has now run its course, meaning that the Nikkei may have reached a very significant bottom at current levels.

A recent article published in Barrons painted a rosy picture of Japanese valuations, with the magazine telling investors to buy "cheap" Japanese stocks. It is common knowledge that Japan is the cheapest on a price-to-book-value basis, and Japanese shares trade today at a price-earnings ratio similar to U.S. equities. Japanese earnings are growing somewhat faster than the U.S., but the main difference is that Japanese interest rates are sharply lower than U.S. rates. More significantly, many feel that the recent return to a more traditional Japanese government means that interest rates will continue to remain low for some time, which should benefit corporate Japan.

Factors that could bolster the neglected market include a strengthening yen; a trend toward consolidation, coupled with foreign investment such as Citigroup's takeover of Nikko Cordial; a boost in leverage by companies that have previously shunned debt; and a growing dividend pool. Finally, Japan strategist Jonathan Allum of KBC Financial Products says the one metric with "an unblemished track record of spotting times to buy" -- when the dividend yield on Japanese equities (1.46%) exceeds the yield on government bonds (1.48%) -- is about to trigger (contrast with U.S. where equity dividend yield is less than half that of Treasurys). Popular U.S.-traded bets include Toyota (TM), Nomura Holdings (NMR), or broad-based funds like iShares MSCI Japan (EWJ) and Japan Small Cap Fund (JOF). (Barron's)

1. Kinda weird, and it makes you wonder, but on the WSJ main page, I could not find a link to Barron’s. I know I’ve seen a link to Barron’s in the past there; I have used it, which is why I noticed its absence today.
2. I found it amusing that the mutual fund that Barron’s would mention on their Blackrock interview, underperformed the Lehman Aggregate over 1, 3 and 5 years. Don’t get me wrong, Blackrock is a great shop, and I would work there if they offered me employment that didn’t change my location. Why did Barron’s pick that fund?
3. I’m not worried about the effect of a financial guarantor downgrade on the creditworthiness of the muni market. Munis rarely fail. Most of those that do fail lacked a real economic purpose. What would be lost in a guarantor downgrade is liquidity. Muni bond insurance is a substitute for analysis. “AAA insured, I’ll buy that.” Truth, an index fund of uninsured munis would beat an index of insured munis, because default rates are so low. But the presence of insurance makes the bonds a lot more liquid, which makes portfolio management easier.
4. I’ve been a US dollar bear for the last five years, and most of the last fifteen years. Though we have had a little bounce recently, the dollar has of late been at record lows against currencies that trade freely against the dollar. I expect the current bounce to persist in the short term and fail in the intermediate term. The path of the dollar is lower, unless the Fed decides to not loosen more. Balance needs to be restored in the global economy, such that the rest of the world purchases more goods and services, and fewer assets from the US.
5. I don’t talk about it often, but when it comes up, I have to mention that municipal pensions in the US are generally in horrid shape. The Barron’s article focuses on teachers, but other municipal worker groups are equally bad off. The article comments on perverse incentives in teacher retirement, which leads older teachers to retire when it is feasible to do so. For older teachers, I would not begrudge them; they weren’t paid that well at the start, and the pension is their reward. Younger teachers have been paid pretty well. I would not expect them to get the same pension promises.
6. I like Japan. I own shares in the Japan Smaller Capitalization Fund (JOF); it’s my second-largest position.
   

   Japan is cheap, and small cap Japan is even cheaper. I would expect a modest bounce on Monday.

7. We still need a 15-20% decline in housing prices to bring the system back to normal. There might be an undershoot in price from the sales that forced sellers must do. Hopefully it doesn’t turn into a self-reinforcing decline, but who can be sure about that? At that level of housing prices, man recent conforming loans will be in trouble, much less non-conforming loans.

Full disclosure: long JOF