Today's comment is by Eric Roseman, Investment Director for The Sovereign Society, and Editor of Global Mutual Fund Investor.

Dear A-Letter Reader:

With the majority of global stock markets now trading at either all-time highs or fresh six-year highs, finding an undervalued bourse is like looking for a needle in a haystack. But one of the cheapest markets this year is still a huge bargain. What's this market? Japanese small caps.

As measured by the Tokyo Second Section Index (Stocks listed on the Tokyo Stock Exchange are separated into the First Section for large companies, the Second Section for mid-sized companies), there are over 500 domestic Japanese small cap issues. Since January 2006, the index has plunged 23% in yen (22% in U.S. dollars). The Nikkei, a composite measuring Japan's broader market, is up just 1% this year after struggling through most of 2006. In fact, Japan is the worst performing major market in the world going into 2007.

Japanese small caps are generally lagging behind the larger cap names. And many are still drifting slightly lower despite increasing evidence of their strong earnings. Valuation levels have come down substantially in 2006, mainly the result of a brutal combination of contracting price-to-earnings multiples and falling stock prices.

The market was hit hard last May after the Bank of Japan (BoJ) announced that interest rates would eventually rise for the first time since the late 1990s. Despite the tough talk on interest rates, Japan is just emerging from years of debilitating deflation, or a period of falling consumer prices. Any hike in borrowing costs is expected to be modest in 2007.

For international investors, especially dollar and euro-based investors, the Japanese yen now trades at a 20-year low, according to the Bank of Japan's proprietary index. Central banks in Russia, Switzerland, and New Zealand are increasing their yen-based holdings on the premise that the yen will rebound from a multi-decade low as the Bank of Japan starts raising rates. That makes buying Japanese stocks even more compelling since foreign currency investors in yen assets should eventually reap an extra capital gain as the Second Section bottoms.

When Japanese small-caps turn around, they recover very quickly. Previous recoveries in the Second Section have been volatile, including a 62.1% gain in 2003 and 51.2% in 2005. In 2003, the Second Section gained 62.1% after plunging a cumulative 25.8% in 2001 and 2002. In 2006, the index has declined 17.9%, implying a typical recovery might result in at least a strong double-digit gain for new investors heading into 2007.

Combined with strong earnings, an accelerating economy, a cheap yen and high stock-market values, Japanese small caps are about to shine in the land of the rising sun.  

ERIC ROSEMAN, Investment Director
On behalf of The Sovereign Society

EDITOR'S NOTE: Look for a way to play Japan's rising interest rates for 487% profits in the December issue of The Sovereign Individual, The Sovereign Society's members-only newsletter. Not a member yet? Click here to subscribe now, for our lowest subscription price ever.