How a broke Japan could be good for stocks

Britain's not the only country mired in debt. The Japanese government is now so deep in the red that it could easily go broke. But paradoxically, that could be good for Japanese equities.

In 2003, Morgan Stanley closed its Asian Equity Fund.

When Asia was a popular investment in the mid-1990s, this fund managed over $350 million. But by 2003, the Asian stock markets had fallen in half. The public didn't care about Asia. Morgan Stanley's fund had shrunk to less than $10 million in assets. The management fees couldn't cover the costs, so Morgan Stanley made a business decision and closed the fund.

Between 2003 and 2007, Asian markets soared. Hong Kong's stock market tripled, for example. Singapore's market tripled. Korea's market quadrupled.

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In 2000, Morgan Stanley's investment management business "heavily" promoted aggressive technology funds. Even though the market had already started to collapse, the public still wanted to pour their money into technology stocks. So Morgan Stanley's salespeople raised as much money as they could.

Two years later, these aggressive technology investments were worthless.

I took these examples from one of my favourite investment books, Hedgehogging by Barton Biggs. Biggs uses these examples to show why you should always do the opposite of what Wall Street salespeople do. If they're selling out and moving on, you should be getting ready to buy. If they're moving in, you should set a tight stop loss. (Don't sell immediately or you could miss the "mania" stage.)

Wall Street firms are in the business of selling products to the public. They aren't investors. "The public never learns," Biggs says, "and the mutual fund industry can never pass up a money making opportunity."

Right now, Wall Street firms are abandoning Japan.

The Nikkei 225 stock average touched its lowest level in 26 years last week. And according to Bloomberg, Goldman recently cut 200 positions in Tokyo. Nomura is eliminating at least 100 jobs. Citigroup's Japanese brokerage is shedding about 1,000 workers. Morgan Stanley, Credit Suisse, and Deutsche Bank are also cutting jobs in Japan.

"Demand for equity analysis is dwindling as overseas investors abandon Japanese stocks, with $13 billion sold in the first seven weeks of this year" says Bloomberg.

In last week's DailyWealth, I showed you that the Japanese government is the most bankrupt entity in the world. As a result, I expect the yen and Japanese government bonds are about to enter a massive bear market.

The paradox is, this could be good for Japanese stocks. The Japanese stock market is one of the cheapest stock markets in the world, with a price-to-book ratio of one and a dividend yield of 3%

A lower exchange rate will be just the ticket to spark a rally in the Japanese stock market. But the real boost comes when savers realise their government is broke... For years, the Japanese have piled their money into government bonds yielding 1% and ignored Japanese stocks. But when the yen starts to falter, they'll dump their bonds and pile into stocks for protection.

I'm not saying Japan is due for a big recovery. But stocks don't need a booming economy to rally. Stocks rally when everyone hates them... when they get so depressed that they simply can't fall anymore.

Wall Street firms are abandoning their Japanese stock market businesses. Now is the time to buy. Investors can own a basket of Japanese stocks through the iShares Japan fund (NYSE:EWJ).

This article was written by Tom Dyson for the free daily investment newsletter DailyWealth