WHY JAPAN IS A GOOD GLOBAL VALUE

JAPAN CONTINUES TO LEAD GLOBAL MARKETS... I've written some recent articles on my belief that the Japanese market represents the best global value at this point in time. Part of that reasoning is tied to the idea that Japan is benefiting from the global swing from deflation to inflation. I've also suggested that the close correlation between rising Japanese stocks and the price of gold strengthens the link between Japan and inflation. I've suggested that the swing toward Asian inflation increases the odds that global interest rates are probably headed higher. Another theme I've mentioned is that Japan has had a low correlation to other global stock markets for the last fifteen years. That suggests that if stock markets (especially in the states) start to weaken, Japan may provide some global diversification. But first an update on the Japanese market. Chart 1 shows the recent upside breakout in the Nikkei Average from a huge "head and shoulders" bottom. The relative strength line along the bottom shows Japanese stocks outperforming the U.S. for the first time in three years (more on that later). The weekly RSI line shows the Nikkei in an overbought territory. But the trend is still clearly bullish. [The Nikkei gained 2.5% last evening and was the world's biggest gainer]. A long-term look at the relationship between the Nikkei and the S&P 500 shows why I think Japan is such a good relative value.

Chart 1

JAPAN VERSUS THE S&P ... Chart 2 compares the Nikkei (orange line) to the S&P 500 over the last 25 years. The first thing that jumps off the chart is that they've been trending in opposite directions since the end of 1989 (first blue line) -- in a very big way. Since most global markets have had a strong positive correlation over that time span, that means that Japan has been badly out of step with the world's other stock markets. And therein lies the major point that I've been making. When seeking any kind of diversification, the best place to look is to another market that doesn't have a positive correlation to other markets. If global markets led by the U.S. start running into trouble, Japan may have the best chances of withstanding a global downturn. In the five years since 2000 (to the right of the second line), the Nikkei and the S&P have trended more or less in tandem. That has led some to question their low correlation. In my view, that's why it's important to look at the last fifteen years -- not just the last five.

Chart 2

RATIO OF NIKKEI VS. THE S&P 500... One of the best ways to compare the relative action of any two markets is with ratio analysis. Chart 3 is a ratio of the Nikkei to the S&P 500 since 1980. A rising ratio during most of the 1980's showed Japanese outperformance. The ratio peaked at the end of 1989 (first circle) and fell sharply for the next thirteen years during which time Japan fell while most world markets rose. The ratio bottomed during the first half of 2003 (second circle) and then proceeded to break a thirteen-year down trendline. [I'm using a logarithmic scale on the chart which is better for long-term trendline analysis]. The breaking of that long-term down trendline suggests to me that Japan may be emerging from a long period of underperformance to a new period of outperformance. Chart 3 also suggests that Japanese outperformance is still in its early stages. Chart 4 gives a closer look at the Nikkei/S&P ratio since 1999. The ratio has just broken out to the highest level in three years (see arrow). That also tells me that the long-term relationship between the U.S. and Japan is undergoing a major change in favor of Japan. If that's a sign that Japanese deflation is a thing of the past, that should be good for inflation assets like gold, but bad for rate-sensitive assets like bonds. It may also put an end to the global housing boom.

Chart 3

Chart 4