Capitalize on Japan's Cyclical Recovery with Small Cap Stocks     

• As far as we can see, there is no denying that a recovery of some sorts is underway, and that stock prices are reading this. For long-term investors however, whether or not this is a cyclical or secular recovery makes a huge difference.
• Further, global equities led by the S&P 500 have come very far, very fast from bear market lows set this March, meaning an interim correction could occur at any time.
• As far as the cyclical bull market goes, however, the S&P 500 has not yet recovered the 1,200 plateau where stock prices literally fell off a cliff in 2008. We believe that continued excess liquidity, short covering, evidence of a mending economy and a continued restoration of equity allocations by institutional investors can push the S&P 500 back to this level before serious upside resistance and or consolidation sets in.
• Thereafter, as was seen in the post IT bubble bear market recovery and in the post Heisei Malaise bear market  recovery, US stock prices could trade in a sideways channel for up to a year before entering the next upleg this time better supported by economic and earnings fundamentals.
• As the Nikkei 225 is now tracking the S&P 500 literally tick-by-tick, and is not expected to provide any significant alpha versus S&P 500 performance until exports revive in a meaningful way (i.e., return to positive year-on-year growth). Japan's Q2 GDP could show a positive surprise of 4% annualized growth or more, boosted by sequential  recovery in exports as well as a big boost to domestic demand from the Aso Administration's stimulus package.  Aggregate corporate profits however are expected to continue declining until the final quarter of the year, when year-on-year comparisons will get substantially easier due to the implosion of earnings in Q3, Q4 FY08.
• While big cap majors have slashed costs in the April~June quarter, there is much to be done to restore sustainable profitability and achieve competitive global scale. Consequently, our preference is for smaller cap value as the best means to capitalize on the recovery in Japanese stocks.

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