Clouds Cover Land of the Rising Sun - Again

Today's comment is by Eric Roseman, our Investment Director and editor of Commodity Trend Alert.

Dear A-Letter Reader,

Nobody said contrarian value investing was easy. And when it comes to Japan, that task continues to be a painful exercise in patience as capital markets continue to decline amid a mish-mash of political uncertainty, a strong yen and stalled economic growth since April.

The third quarter has been a bad period for global stocks as investors grapple with a crash in sub-prime mortgage-backed securities, a funding crisis in global short-term money-markets and several hedge fund and bank failures in Europe and the United States. The MSCI World Index of industrialized stock markets has declined 2.2% since June 30.

But in Japan, the global sell-off has morphed into an extended bear market. Stock-market values continue to get cheaper following the resignation last week of Prime Minister Shinzo Abe. Handcuffed by a minority government and a host of ministerial resignations all summer, Mr. Abe's departure added fuel to a bear-market fire in Japanese stocks.

Surprising global investors, Japanese second quarter gross domestic product actually contracted 1.2% in the April to June period. It was the first quarterly contraction in four years following a string of bullish economic data for more than 48 months.

Investors Shy Away from Japanese Stocks

Making matters worse, a sharply stronger yen currency since late July has punctured the export sector where Japanese multinationals have relied on a cheap currency to gain international market share.

Japanese stocks, despite offering some of the best values based on a price-to-book-value ratio and price-to-cash-flow basis are still trying to find a bottom. The Nikkei Index of large-cap stocks has declined 6.4% in dollars this year. Meanwhile the even more distressed and cheaper 2nd Section Index of smaller companies has shed more than 10%.

It seems despite generally good corporate results for the entire market this year, investors just don't want anything to do with Japanese equities.

Will the Carry-Trade Come Back to Life?

What Japan needs now is a leader capable of carrying out the economic reforms implemented by former Prime Minister, Junichiro Koizumi. The main contender to fill Abe's shoes, Yasuo Fukuda, has vowed to follow in Koizumi's footsteps.

Fukuda doesn't offer bold economic policies and doesn't even enjoy wide popular support. But he does have all the right connections in the upper and lower Japanese houses. That's a pivotal advantage if economic reforms are to be continued and even accelerated under the LDP or Liberal Democratic Party.
Indeed, international investors - responsible for more than 50% of daily trading volume in Japanese shares, would probably lift the depressed Nikkei and 2nd Section from the near-abyss on any positive political developments.

Other Uncertainties

Other factors contributing to market uncertainty is the Bank of Japan and the yen. The yen has rallied 8% from its lowest point in July versus the U.S. dollar as the infamous carry-trade has lost its momentum since markets peaked on July 19.

The Bank of Japan has threatened to continue raising short-term interest rates following its first hike last spring to a still historically low 0.50%. But throughout the summer, the Bank of Japan (BOJ) threatened to continue tightening monetary policy. The BOJ was hoping to raise interest rates to "normal" levels after years of ultra-loose monetary policy designed to resuscitate the deflationary-plagued economy from 1991 to 2003.

But with global money markets under the gun since July, the Bank of Japan is unlikely to resume rate hikes and that implies a gradual return to the carry-trade following the restoration of market stability, which has already begun since the Federal Reserve cut its discount rate on August 17 and the Fed Funds rate on September 18.

The carry-trade has been instrumental in fueling global liquidity and investors and traders alike have borrowed cheap yen at low interest rates and reinvested those proceeds into higher-yielding assets. The odds of the carry-trade returning, even grudgingly, will boost world markets and reduce the yen's value versus most global currencies. And that event alone should be enough to propel Japanese stocks higher.

Don't Dump Japanese Stocks Now

At this stage, I would continue to hold Japanese stocks and refrain from selling cheap securities. Cheap is getting cheaper in Japan. But at some point, investors will be rewarded and rather quickly.

Compared to the rest of the world, Japanese smaller companies trade at 65% - 80% discounts based on relative price-to-book-value ratios. The current price-to-book-value ratio of the Tokyo 2nd Section Index is 0.90 or a 10% discount to book-value.

And unlike larger Japanese companies, they don't rely on a cheap yen to boost exports, which makes this ongoing bear-market in values even more difficult to comprehend considering earnings have been mostly robust since 2003.

Japanese Small-Caps: Still Selling at a Value

In a market where just about everything has gone from bad to worse this year for investors, Japanese equities remain excellent values and should not be sold at these distressed levels.

A new Prime Minister, which will boost market sentiment by reinforcing economic reforms started under Koizumi, will probably act as the catalyst to finally drive equity prices higher. Stay invested in Japan.

ERIC ROSEMAN, Investment Director

Important Update on the U.S. Passport Debacle

The U.S. Department of State has issued a reminder that all U.S. persons traveling outside America will again be required to present valid U.S. passports for reentry into the United States. This goes into effect October 1, 2007, in compliance with the so-called "Western Hemisphere Travel Initiative."

This passport requirement for air travel went into effect on January 23, 2007. But due to the government's incompetence and inability to process passport requests, the government temporarily instituted a waiver for U.S. travelers who could show proof of having applied for a passport.

That waiver ends Oct. 1, 2007. After that date, all returning U.S. persons must have a valid U.S. passport in order to re-enter the United States.

BOB BAUMAN, Legal Counsel

Wealth & Investments

Wanted: A Full Accounting of
Wall Street's Dirty Laundry

Aside from the high-drama being provided today by the FOMC meeting; another interesting side-show in this week's circus-like environment is the fact that Wall Street's top-dogs are scheduled to release their latest earnings reports.

This will give investors the first look at the financial industry fallout from this summer's credit crunch. This is only fitting, since the turmoil has at least in part, been a market shock of Wall Street's own making.

Big banks and brokerage firms earned a mint in recent years by packaging up and selling the mortgage-backed derivatives that are now at the heart of the credit crunch. So in effect, Wall Street sowed the seeds for the sub-prime debacle; and now gets to reap the whirlwind of the credit crunch firsthand.

Lehman Brothers (LEH) leads off the hit-parade of profit (or loss) reports today, followed by heavyweights Morgan Stanley (MS) on Wednesday, and both Bear Stearns (BSC) and Goldman Sachs (GS) report Thursday. A regular rogue's gallery of Wall Street's walking wounded!

What investors are looking for out of these brokerage firms' is not necessarily the bottom line facts and figures - these are most likely dismal to be sure.

In fact, investors are bracing for what Bloomberg says could be "the worst year-on-year decline in earnings per share since the second quarter of 2005" for Wall Street.

If you subtract a one-time gain on asset sales booked by Goldman Sachs last quarter, this could prove to be the biggest decline in Wall Street profitability since 2001!

Bear Stearns for example, which suffered two hedge fund liquidations in June, is likely to report that second-quarter profits fell nearly 50% year over year.

So the negative earnings reports to come are in some respects already reflected in slumping broker share prices. But the question will be: Has all of Wall Street's dirty laundry been aired out yet?

The key in these reports will be the "forward looking statements" and "guidance" (if any) from the titans of Wall Street...and the key word to search for is: "transparency." Investors are desperate to know whether Wall Street has yet been able to assess the full extent of sub-prime related losses.

The real bottom line is that financial market participants are suffering from a crisis of confidence in the system itself. Investors are unsure if the checks and balances are in place to limit losses in opaque derivatives tied to sub-prime mortgage loans, and other asset-backed "paper." When it comes to accounting for the true market value of Wall Street's credit derivatives, the following excerpt from Bloomberg says it all (emphasis is mine):

"Prices for some instruments are either unavailable or unreliable, turning such mark-to-market accounting into guesswork. Many securities have all but stopped trading since the sudden increase in defaults on sub-prime home loans early this year left investors leery of products with limited transparency, such as mortgage-backed bonds and collateralized debt obligations."
What financial markets need to settle down to business as usual again; in fact what they're demanding, is a full accounting for the supposed value that backs up all those "pieces of paper" floating around the global financial system.

In other words the question is: Can Wall Street back up its derivative "promises?"

The shadowy world of complex financial derivatives is a US$415 trillion market - equivalent to eight times the value of the world's total economic output - and yet it's a largely unregulated market where transactions are made between, and values fixed by, big banks and brokerage firms with little oversight, and even less transparency.

It is high time Wall Street opened the shades and let a little sunlight shine in on the full extent of sub-prime derivative losses, investors need such transparency to fully regain confidence in financial markets.

In the absence of such candor from Wall Street this week, we are bound to see more market shocks impacting the financial world and disrupting your portfolio.

MIKE BURNICK, Senior Editor & Global Markets Analyst