In the Land of the Rising Sun, the financial sun is apparently setting. I have zero investments today in Japan for the reasons outlined in the story linked below. Credit Default Swaps (CDS) are showing the Japanese banks are under great stress. Those bank debt insurance policies are at levels close to where American banks were in September 2008 before the big crash and bank implosion.

I have business associates in Japan, and the economy has been in virtual depression for many years. They have a homeless problem like you would not believe with tent villages on public grounds in the cities, especially around the old castles (but being Japanese, they are very tidy tent villages).

From my take on the Japanese people, the problem is mostly to do with their domestic reluctance to consume. They have a domestic consumption economy much too small for the size of the country (by population). The older generation that came of age post WW2, was reluctant to spend on anything, understandably so given what they went through in the years after 1945. Even the business leaders who make a very nice income by American standards, are very frugal in how they live. The wages for the workers among the younger generations are very modest. I was able to determine that a sales person selling the same products as me, with the same skill set and experience, was making half the wage. The Japanese I know can’t believe how well we live here in America and some consider us wasteful and decadent (though they enjoy participating in the decadence when they visit).

And with the WW2 generation being very conservative about their own future, they had small families with birth rates below the “replacement rate” of about 2.2 children per family. This, along with virtually no immigration, leads to the well known problem of Japan’s gentrification. Who is going to take care of all the older people on government pension and healthcare?

And now Japan has lost the one thing that kept it going and growing the past 40-50 years: a leading global position in manufacture and export of consumer goods. China and its siblings (Taiwan, Singapore, Thailand, Vietnam, etc) are taking over this role on the world stage. Japan is left to try and export capital goods and engineering know-how to China and siblings, much like America. But America has a population that always expands from immigration (a reason I am VERY pro-immigration) and an established consumer psychology that will recover within the next few years, Bill Gross’ proclamations to the contrary. Our desire to consume is genetic. It is the source of the proverbial “American Dream”.

A second significant problem for Japan is that Japan has no natural resources to export. So, they have lost their consumables export leadership and have nothing left to sell the rest of the world to drive their economy. Japan does not consume enough as a nation to fully utilize its own productive capacity for domestic demand and to keep its younger workers employed to pay for the retirements of the older workers. This is the source of Japanese deflation.

I think Japan will either evolve out of necessity into a consumer nation over the next 20 years as the younger generations with Western ideals take over management of the country, or Japan’s financial system will go into default. In October last year, the world financial system came to the rescue of America with its heavy importation of manufactured products and its reserve currency. The world had to save American banks in order to save itself. But for Japan, there will be no such salvation. Its banks will be allowed to fail and the Japanese people will have to build the country all over.

If Japan defaults, it will be VERY ugly (Iceland times 100). So, I expect global financial interests to push the Japanese to avoid that fate before it happens. Ironically, the Japanese need to spend their savings (those infamous Postal accounts). That is their one chance to save themselves and the rest of the planet a lot of pain. Strange as it seems for Americans with our low national savings rate, it is possible for a nation to be too thrifty (called “The Paradox of Thrift”). There is a need for balance in a sustainable economy: not too little savings, but not too much; not too little social security, but not too much (Obamacare for example); not too little immigration, and not too much. And so on.

Just be glad this is happening now and not in 1990. The Japanese economy (including real estate and stock market) has already deflated by 80%. The crash if it happens, will not be as precipitous from these levels as it could have been. But it is shocking to contemplate. I think the weakness of Japan’s economic system, its lack of domestic consumption and its long term social liabilitites, is the reason the Yen will never become the world reserve currency. The dollar remains safe in that role for some time to come.

Here is a link to the article that inspired this post published in the UK Telegraph on Sunday (bottom of post). It is somewhat frightening reading. But as mentioned, I don’t think the Japanese economy has a great deal of direct influence on the Rest of the World. Besides, as Warren Buffet says (quoting someone Ben Graham I believe), “Buy when everyone is Fearful and Sell when everyone is Greedy”. He did that today when he acquired ALL of Burlington Northern Santa Fe rail (BNI) for $44B.

“It is Japan We Should Be Worrying About, not America”

Fluor Engineering has many positive attributes.  FLR has a P/E of 12 and an almost guaranteed profit for the next 12 months due to the contractual backlog that is inherent to engineering construction companies.  Its Revenue / backlog is $23B while its Market Cap is only $8.6B for a very low P/S ratio of 0.37. This while the ROE is 26.71%.  Engineering construction is a high margin business. (all numbers as of October 2, 2009)

The long term outlook for engineering construction is very good globally with infrastructure and natural resource processing required in Emerging Markets and as a form of stimulus in developed markets. FLR was at 100 in June 2008 and tracks very close with energy and materials stocks as that is where FLR does most of its projects. Its five year low was 28.60 on Nov 20 during the panic. I can’t imagine prices getting back to that level again:

Take a look at this ITM call spread. Underlying: FLR at $47.60 (Friday close)

Buy APR ‘10 $40 CALL (FLRDH) for $10.50

Sell APR ‘10 $65 CALL (FLRDM) for $1.10

Net Cost = $9.40 per contract (100 shares

Upside is 166% Return in 6.5 months (note that the time premium degrades closer to expiration which causes return to decrease)

Downside is 40 – 1.10 = 38.90; return = zero;

Any close above $49.40 at April expiration will be profitable

A $9400 investment would buy 10 contracts and allow the possibility of a $15,600 return

======================================================================================

To provide a little better downside protection in return for giving up some upside, go deeper in the money to the $35 CALL:

Buy APR ‘10 $35 CALL (FEMDG) for $14.60

Sell APR ‘10 $60 CALL (FLRDL) for $1.90

Net Cost = $12.70 per contract (100 shares)

Upside is 97% Return in 6.5 months (note that the time premium degrades closer to expiration which causes return to decrease)

Downside is 35 – 1.90 = 33.10; return = zero;

Any close above $47.70 at April expiration will be profitable (basically, just above the current price)

A $13,970 investment would buy 10 contracts and allow the possibility of a $13,530 return

Another possibility is to just buy the shares outright and then sell a $60 April Call against them for $1.90. But that reduces the return and really doesn’t provide much benefit in reduced risk. Chances are the time premium on option 1 of $2 between now and April will be rewarded. It is not much to pay for the chance at a 100% return in 6 months

Flash Player 9 or higher is required to view the chart
Click here to download Flash Player now

I attribute recent price weakness (past two weeks) to profit taking.  The past nine months had seen an almost 100% price rally from the November low.  But fundamentally, FLR is very sound.  If you believe as I do, that global growth will continue, especially in the Emerging Markets, FLR is very well positioned regardless of problems in the American economy.

There are many doomsayers on the economy and markets. They all say roughly the same thing: we have been profligate as a nation and as a world, and there is a big price to pay. This price will be paid in the form of a very long period of economic stagnation and declining markets. The doomsayers give many seemingly sound reasons for their outlook, that to some may seem irrefutable evidence of a coming economic armageddon.

Unfortunately, history does not support their thesis. If anything, what economic history proves is that there is a wired-in persistence of growth in the economy. When we look at our financial surroundings on a day to day basis, we get confused by the noise. Daily, monthly, even quarterly data might seem to indicate some watershed change in the economic future. But the facts show us that year after year, decade after decade, the economy continues to grow very evenly and consistently. The markets will mirror this growth in the long term, and once all the daily noise is removed.

Here is a chart I prepared showing this persistence. It dates from the earliest Gross National Product data available on the government economic data website. It shows that even the 1930s disaster looks relatively benign in an 80 year perspective.

The conclusion: invest for the future, not the next day. And you will be richly rewarded for your patience.

James Grant penned a commentary in the weekend edition of the Wall Street Journal (September 19, 2009).  James is always worth reading (Grant’s Interest Rate Observer).  He has been a moderately bearish commentator for as long as I have been reading his work (10 years), most often in Barron’s articles.  He has bemoaned the high consumer and national debt and the very low (even negative) personal savings rate in America.  For this, he has called for a weak dollar and higher interest rates for the past decade.

That he flys in the face of his brethren bears is of no small consequence to me.  Normally James Grant’s perspective is closely aligned with so-called other “bond vigilantes” like Bill Gross at PIMCO and perma-bears like Bill Fleckenstein or Peter Schiff.  Those other dollar sellers / interest rate watchers are still looking for a flat to declining economy and dollar and moribund economy.  Grant really is making a departure from his club here, which is good because it is contrary.

He was early to call the stock market decline, as far back as 2005.  But this is news: now he sees it is time to become Bullish, if for the all the wrong reasons in his view.  James Grant is leaving the Bear camp (maybe six months late).   Here is an excerpt from his article.  Click here to read the entire piece from the WSJ.

Though we can’t see into the future, we can observe how people are preparing to meet it. Depleted inventories, bloated jobless rolls and rock-bottom interest rates suggest that people are preparing for to meet it from the inside of a bomb shelter.

The Great Recession destroyed confidence as much as it did jobs and wealth. Here was a slump out of central casting. From the peak, inflation-adjusted gross domestic product has fallen by 3.9%. The meek and mild downturns of 1990-91 and 2001 (each, coincidentally, just eight months long, hardly worth the bother), brought losses to the real GDP of just 1.4% and 0.3%, respectively. The recession that sunk its hooks into the U.S. economy in the fourth quarter of 2007 has set unwanted records in such vital statistical categories as manufacturing and trade inventories (the steepest decline since 1949), capacity utilization (lowest since at least 1967) and industrial production (sharpest fall since 1946)……

…..By rallying, equities and corporate bonds not only anticipate recovery, but they also help to bring it to fruition. By opening their arms wide to such previously unfinanceable businesses as AMR Corp., parent of American Airlines, and Delta Air Lines Inc., the newly confident credit markets are implementing their own stimulus program. “Reflexivity” is the three-dollar word coined by the speculator George Soros to describe the dual effect of market oscillations. Not only does the rise and fall of the averages reflect economic reality, but it also changes it. One year ago, the Wall Street liquidation stopped world commerce in its tracks. Today’s bull markets are helping to revive it.

I promised to be bullish , and I am (for once)—bullish on the prospects for unscripted strength in business activity. So, too, is the Economic Cycle Research Institute, New York, which was founded by the late Geoffrey Moore and can trace its intellectual heritage back to the great business-cycle theorist Wesley c. Mitchell. The institute’s long leading index of the U.S. economy, along with supporting sub-indices, are making 26-year highs and point to the strongest bounce-back since 1983. A second nonconformist, the previously cited Mr. Darda, notes that the last time a recession ravaged the labor market as badly as this one has, the years were 1957-58 —after which, payrolls climbed by a hefty 4.5% in the first year of an ensuing 24-month expansion. Which is not to say, he cautions, that growth this time will match that pace, only that growth is likely to surprise by its strength, not weakness.

And that is my case, too. The world is positioned for disappointment. But, in economic and financial matters, the world rarely gets what it expects. Pigou had humanity’s number. The “error of pessimism” is born the size of a full-grown man—the size of the average adult economist, for example.