Japan Stocks: Time to Look at the Small Cap Trees   

• The global financial crisis that erupted following the bankruptcy of Lehman Brothers last fall has been contained, and it is apparent that we have already seen the worst of the economic contraction caused by this crisis.
• The $60,000 question now is, what kind of recovery will this be, i.e., "L", "W", or square root? No one seriously believes in a "V"-shaped recovery, and history argues strongly against it, given the track record of past recessions involving a financial crisis, crash in property prices and consumer recession.
• "Normal" recoveries usually involve the first stage of the market rally being driven by excess liquidity (monetary stimulus), an interim correction as the monetary authorities remove what becomes excessive stimulus, and then a resumption of the market rally driven by economic and corporate fundamentals.
• Given other than a "V"-shaped recovery, this transition will may not be smooth or timely, and may resemble the recovery in Japanese stocks coming out of the Heisei Malaise. In Japan's case, the market rallied some 58% in two waves from 2003 lows, then traded between 10,000 and 12,000 for about a year before the fundamentals caught up and drove the market to an eventual high above 18,000.
   
  Japan's Nikkei 225 briefly has now recovered 10,000, but has been unable to hold this level despite growing confidence in the government that the economy has bottomed. Investors are worried that the same old prognosis, i.e., public works expenditures putting picks and shovels to work, will merely provide a temporary respite and only leave (as it always has) a negative legacy of more government debt that strangles a return to higher secular growth.
• Thus the top-down case for Japanese equities remains a relative one at best, particularly vis-a-vis 7%~8% growth in China and higher growth in the BRICs nations.
• This however does not mean there are no more opportunities in individual stocks, particularly in mid- and small-cap stocks that should now outperform as the global financial system is stabilized and global economies slowly begin to mend.

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