Bullish News for the Most Unloved Japanese Assets

I'm loathe to give Japan any pub, but as a service to my growing readership, I feel an obligation to mention it for those of you exploring investment options outside the US shoreline.
As a global investor, I'm constantly on the lookout for juicy bits of international news that might affect the markets and my portfolio plays. And last week, my research really hit the jackpot
On June 13th, Japan's national pension fund said it plans to invest in Japanese smaller companies for the first time ever.
This may not sound that significant. But it means the world's largest pool of retirement funds is heading straight for Japanese small-cap stocks. In fact, Japan's Government Pension Investment Fund will pour almost US$100 million into Japanese smaller stocks this year alone.
Why This Matters to Someone Outside of Japan
So why is this important? Up until now, this pension fund has only invested its US$912 billion in assets in large-cap stocks as defined by the Tokyo Nikkei 225 Index. But now, for the first time ever, they're switching to the undervalued and very attractive small-caps; which provide a big boost to Tokyo Second Section Index, which tracks Japanese smaller company stocks.
The unloved Japanese small-caps desperately need some bullish news to boost prices. Since mid-2005, the Second Section has ranked as Asia's worst-performing index. Over the last 18 months, the Second Section has plunged by a third from its peak. Meanwhile the smaller Mothers Index of micro-caps and many technology stocks has tanked almost 50% from its best level.
But last week, this index took a turn for the better. The Second Section posted its biggest five-day rally since last winter, and the index has also gained more than 6% this month.
The Aging Japanese Baby Boomers
It's easy to see the Japanese government is using this strategic move.
Japan is desperately trying to increase the value of its pension reserves, to accommodate its aging population. Right now, Japan has the fastest-aging population among the world's largest industrialized economies. Approximately 6.8 million baby boomers are set to retire this year. According to the Japanese Government Pension Investment Fund, pensioners will make up more than 25% of the population by 2025!
So Japan must boost returns on their pension funds to meet the aging population's healthcare concerns. To finance the bulging costs of healthcare, the government will increase its risk aversion by diversifying away from the stodgier large-cap stocks in the Nikkei 225 Index.
Small-caps, though certainly more risky, have outpaced larger stocks in most markets around the world. Historically, small-caps offer superior earnings growth and greater flexibility to adapt to changing market conditions. And Japanese pension fund managers are eager to tap into this kind of potential.
Japanese smaller stocks have gone from boom to bust on numerous occasions in the past. Volatility is intense, so timing is critical in this market, but the rewards can also be staggering. When small stocks in Japan plunge, they crash anywhere between 30% to 50% - sometimes more. But when they recover from a bear market, which is the case now, gains can range from 60% to 100% in a short period of time.
Japan Inc. - an Entire Region of Undervalued Opportunities
I've visited Japan three times since June 2006. From an investment perspective, I see the entire economy as undervalued compared to other industrialized countries.
For the first time in history, Japanese companies, both large and small alike, have been buying back their stock. They're paying dividends to shareholders and harboring some of the highest per share cash-flow ratios in the world.
Make no mistake about it - corporate Japan is in the midst of a huge comeback! Capital spending remains brisk, earnings are strong and exports are booming. It's no surprise that many of the world's most profitable value-based money managers are turning bullish on Japanese equities.
The big problem in Japan, however, remains consumer spending. Right now, consumer spending is responsible for 75% of consumption, and the Japanese consumer continues to grudgingly increase spending. The good news is that compared to 12 months ago, retail sales have marginally increased - a major plus for the economy. Boosting consumption is a low unemployment rate of 4% and the boom in outsourcing.
Japan was very slow to adapt to the new Asian economic model more than a decade ago. At the time, low-cost manufacturing centers in China and elsewhere devoured Japanese market share, inhibited by a strong yen. But since 2000, Japan Inc. has aggressively moved the bulk of her manufacturing prowess outside of the country to Mainland China and elsewhere, exploiting far lower wages and tax rates.