My initial reaction to the negativity:

Although no one can be certain of the outcome, the British weekly is a contrarian indicator on many topics, and Japan is one of them.

When The Economist has mentioned Japan in the past, the market was ready to turn around, either to the upside or the downside, but always on the opposite direction of which the article had indicated. The usual time frame for the turnaround is between one and 18 weeks. Hopefully, the success of The Economist’s forecasts will continue.

I’ve made the case for Japan’s long-term potential on numerous occasions. The main idea is that the current economic cycle in Japan will be stronger and more enduring than most market observers anticipate. This view is based on the structural changes taking place in the Japanese economy (including changes in government financial institutions) and the eventual end of deflation.

On the latter point, the latest Consumer Price Index (CPI) numbers offer encouragement. The chart below depicts Japan’s CPI, minus food and energy. For the first time in the last 10 years, it’s risen by 0.1 percent year-over-year. Although this is a small move, it’s monumental for Japan–especially if it sticks–because it excludes the inflation threats of food and energy.

Short-term market volatility aside, for long-term bulls on the nation’s economy, Japan’s confidence and its exit from deflation is all that matters. The normalization of rates increases the alternatives available for the Japanese so they can use their substantial bank deposits in more productive and profitable ways. Investors who don’t think Japan’s deflation years are over shouldn’t own Japanese stocks.

Source: Bloomberg

Japan is still in a secular bull market that commenced in 2003, and despite its recent weakness, the Topix Index is building a good base around 1,200. See the chart below.

The majority of investors now have little interest in Japanese stocks, in stark contrast to the beginning of 2006. Investors then were influenced by the strong rally in the second half of 2005 and couldn’t get enough of Japan.

The recent action is positive because it’s relatively early, and we still have time to buy into this potentially rewarding investment story. I’m moving Japan up in the Fresh Money Buys ahead of Taiwan.

Source: Bloomberg

Long-Term Holdings Portfolio denizen Mitsubishi UFJ Financial Group (Japan: 8306, NYSE: MTU) is my favorite Japanese bank and reflation play. I reiterated it as a buy two months ago, and it’s gained 17 percent since then. See Silk, 27 February 2008, A Year of Consolidation.

Mitsubishi UFJ has made proper, stockholder-friendly moves during these volatile times. It’s announced a dividend increase–always a pleasant surprise in Japan–and has been buying back shares for the first time.  The bank is also evaluating acquisition targets given the low sector valuations because of the global credit woes.

Finally, the political situation in Japan remains murky, and former Prime Minister Junichiro Koizumi is greatly missed. The unwillingness of the current government to be more proactive with economic change will hurt Japan in the short term. It remains to be seen if Japanese authorities will be able to effectively navigate the economy back to normality (i.e., out of the deflation trap) and allow it to flourish once again.

On the other hand, if everything was politically harmonious in Japan, there would be no value opportunities. Buy Mitsubishi UFJ Financial Group.

The markets continue to probe the proverbial wall of worry, seeking a way higher. It remains to be seen if this rally will stop soon or if we’ll enjoy an explosive ride to the upside. I still expect more gains to come our way, but we should pay attention to the increased volatility.

The Silk Volatility System (SVS) I introduced a couple weeks is a valuable guide. See Silk, 16 April 2008, A Bridge Across the Straits. 

Continue buying into the Silk Portfolio holdings and maintain a balance between both steady capital appreciation and growth-oriented, diverse recommendations.  

The investment process is constant. So if you’d like to add to your positions in portfolio recommendations or allocate new funds in a diversified way, focus on the following markets, in order (for both countries and sectors). Consult the Portfolio tables for details.

• Russia (energy, telecommunications)
• Hong Kong (banking, real estate, infrastructure)
• India (pharmaceuticals)
• Philippines (telecommunications, real estate)
• Singapore (banking, telecommunications, industrial)
• China (consumer, telecommunications, machinery, oil, e-commerce, coal)
• Japan (banking)
• Taiwan (ETF)
• South Korea (banking)
• Cambodia (casino/hotels)
• Macau (casino/hotels)