My #1 Bet in Global Stock Markets

You may have heard about the recovering economies of the United States and Europe, each expanding at a roughly 2% rate of economic growth.

But chances are you have not heard much about the world’s third-largest economy, Japan. As it turns out, Japanese economy is jumping.

Just yesterday, the government announced that Japanese gross domestic product (GDP) grew at a 4% annual rate in second-quarter 2017 to smash all expectations. It also extended the Japanese economy’s longest streak of uninterrupted expansion to six quarters. That’s the longest in 11 years.

Japan’s labor market is tight. Business confidence is high. Investments connected with the Tokyo 2020 Olympics are boosting growth. On a panel on global investing I chaired at my Eagle Financial Publication’s colleague Mark Skousen’s FreedomFest event last month in Las Vegas, Asian investment expert Keith Fitz-Gerald pointed out that he detected more energy and activity in the Japanese economy than he had in decades. He should know. He lives there.

It is no surprise that the Japanese stock market is rallying. The large cap Nikkei 225 Index is well on its way to six consecutive years of positive returns — a feat it last achieved during the bubble years of the 1980s. Japanese small-cap stocks are leaving their large-cap counterparts in the dust, having soared over 24.04% over the past 12 months. Despite their impressive recent performance, I believe the Japanese small-cap stocks could still double over the next two years.

The Japanese Bubble Revisited

Say the word Japan to a global investor, and you think “stagnation,” “malaise” and the “financial bubble popping.”

It wasn’t always so.

Thirty years ago, Japan was the “China” of its day. In his novel, “The Rising Sun,” author Michael Crichton lamented that Americans had to accept the inevitability of a country the size of Montana dominating the United States economically.

American MBA students studied Japanese to get an edge in the job market. Tokyo was one of the globe’s leading financial centers alongside Wall Street. Blue-chip stocks on the Tokyo Stock Exchange routinely traded at price-to-earnings (P/E) ratios of 150. U.S. business school professors studied Japanese management techniques. In the 1980s, not owning Japanese stocks was a career-threatening move.

Then the bubble burst.

After nearly reaching 40,000 on December 29, 1989, the Nikkei index plummeted more than 70%. The Nikkei closed at 19,753 yesterday — almost 28 years later. A country that once accounted for 30% of the global stock market capitalization all but disappeared from the radar screens of U.S. investors. Today, an entire generation of U.S.-based professional investors have never invested in Japan.

Why Invest in Japanese Small-Cap Stocks

After spending almost three decades in the doghouse, here’s why I think the Japanese stock market’s recent rally is set to continue.

First, the Japanese government is doing everything in its power to revive the Japanese stock market. The Bank of Japan has doubled its annual exchange-traded fund (ETF) buying target to ¥6 trillion ($48 billion). Japan’s Government Pension Investment Fund, the world’s largest, now invests 25% of its assets in Japanese stocks. And yes, even skeptical foreign investors are once again investing in Japan.

Second, Japanese small caps are both hated and ignored. Since the Japanese stock market peaked in 1989, trading volumes in Japanese small caps have all but evaporated. Investment banks and brokerages produce next to no research on lightly traded Japanese small caps. And what little research there is rarely gets translated into English. No wonder individual Japanese investors dominate the small caps, accounting for 60% to 80% of trading on JASDAQ, Japan’s version of NASDAQ.

Third, the valuation case for Japanese small caps is compelling. Hundreds of stocks trading at less value than the cash on their balance sheets. That means that investors can buy some Japanese small-cap companies for free. Japan is one of the few stock markets where the father of value investing, Benjamin Graham, could still employ his “cigar butt” approach to investing. All this makes Japanese small-cap stocks the cheapest asset class in the developed world. And by some measures, Japanese small-cap stocks are cheaper than those in Russia.

The #1 Way to Profit from Japan’s Small-Cap Rally

As irrational as the exuberance around Japan’s prospects was in the 1980s, today’s despair is just as far off the mark. Japan today reminds me of commodities at the height of the tech boom, when Merrill Lynch shut down its commodity trading desk in 1999, just as commodity prices bottomed.

State Street bank did something very similar when it shuttered its small-cap Japan ETF SPDR Russell Nomura Small Cap Japan (JSC) last year, almost at the exact bottom of the market. Almost like clockwork, Japanese small-cap stocks began to soar.

Luckily, you can still invest in Japanese small caps. My favorite way is through the WisdomTree Japan SmallCap Dividend (DFJ). Despite rallying 24% over the past year, DFJ remains remarkably cheap. As of June 30, 2017, the companies in DFJ were valued at a mere 0.58 times price to sales and 1.11 to book value. By way of comparison, S&P 500 stocks now trade at 2.14 times sales and 2.88 times book value.

That means that Japanese small caps could double or even quadruple before matching U.S. valuations.

P.S. If you want to profit from the recommendations of my monthly investment newsletter, Smart Money Masters, consider joining along with my current subscribers who are up more than 42% in a recommendation I advised them to buy on Feb. 10. Click here for details.

In case you missed it, I encourage you to read my e-letter from last week on how high intelligence may not necessarily be an advantage when it comes to investing.