Bargain Seekers Beware

03/15/2011 12:44 pm EST

Focus: MARKETS

Chris Gilchrist

Editor, The IRS Report

While steep market drops hardly come as a surprise, the experience of investors in Japan argues against premature bargain hunting, writes Chris Gilchrist in The IRS Report.

The world is full of roaring bulls [or was when this was written earlier this month—Editor], but we are more cautious.

As befits people who want to preserve what we've got, we are keen to avoid unnecessary risks. And we can see lots of potential trouble ahead.

Those fears can lead to paralysis—I expect you know people who keep almost all their money in the bank because there is always some fear that makes any long-term investment seem too risky. Today, oil price escalation, Chinese chaos, Eurozone fragmentation, and debt defaults are just a few themes that might lead you to take money off the table.

What most of us writing for this newsletter think will happen is more turbulence, which may see prices in specific markets falling abruptly by 10% to 20%. But this is just how financial markets always are—we have an ideal of stability, but it is very seldom realized in fact.

That volatility is why we expect to—and usually do—get much higher returns than fearful investors.

So we are not about to U-turn on our belief that stock markets will make us serious money. But we are collectively more cautious than many investment managers who are predicting 10% to 20% market gains this year.

Witness Japan
Since the bursting of its credit bubble in 1989, Japan (EWJ) has been a graveyard for long-term equity investors. Rally has followed rally, only to be followed by another slump in prices.

The cumulative loss from the 1990 peak reached 79% when the Nikkei-225 index touched its low of 7,300 in February 2009. Over those two decades, investors did make money in government bonds, despite their low yields, because of deflation—this was what strategist Albert Edwards first christened the “ice age,” which he still expects to hit Europe before long.

After being burnt in one or two of these rallies, most professional investors have remained resolutely underweight in Japanese shares for most of the past decade. That's been a good call for long-term investors: it's easy to lose money trying to trade rallies.

But in the last two years, thanks to appreciation of the yen, unhedged investors in Japan have done pretty well, with returns of 40% to 60%. [These have likely now been significantly reduced by the Nikkei’s 17% plunge since disaster struck—Editor.]

The big negative is that Japan's fiscal position is so dire it makes the US look virtuous. One-fifth of all government revenues go to debt repayments. Total government debt is 20 times revenues (that is seven times higher than the US ratio that has Republicans frothing at the mouth.)

Fears that the government simply cannot finance more borrowing could prompt a yen sell-off and rising interest rates.

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