HARD TO BELIEVE

These days, however, the news out of Japan couldn't get much worse.

Japan has suffered four official recessions in the last decade. Industrial output is at a 13-year low, and the unemployment rate is at a postwar high, with roughly 50 jobs per every 100 job seekers. Household spending has fallen for six consecutive months and consumer confidence it at its lowest level in three years.

Standard & Poor's downgraded the national credit rating, which along with Italy's, is now the lowest among the G-7. The rating agency also put Japan's biggest banks, such as Mitsubishi Tokyo Financial Group on "credit watch," essentially the financial equivalent of the scarlet letter.

The Nikkei 225, Japan's benchmark stock index isn't far from 17-year lows. Since it peaked at 38915.87 on Dec. 29, 1989, it has fallen some 72%. And although a similar move in U.S. stocks would see the Dow Jones Industrial Average fall to roughly 3500 (a level we haven't seen since 1994), most pundits are far more ready to bottom fish in the U.S. than Japan.

In October, Merrill Lynch's senior Japanese strategist recommended selling Japanese stocks, and in November, Goldman Sachs cut Japanese stocks to a Neutral rating in its global asset allocation, admitting in a research report that "we are increasingly downbeat about Japan's growth prospects." The bank also postponed its planned listing of a Japanese REIT, citing the country's deteriorating real-estate market.

Japanese institutional investors, who already own primarily U.S. stocks, plan to increase their allocation at the expense of Japanese shares, in which most are decidedly underweight. According to a recent Reuters poll, the average Japanese institutional investor had 42% of assets in U.S. stocks, compared with just 22% in Japanese shares.

U.S. fund managers have also steadily decreased their exposure to Japan. Two years ago, global equity portfolios had approximately 16% of their assets in Japanese stocks. Today, that level has fallen by one half.

As the Nikkei has collapsed, so has direct foreign investment. French cosmetics chain Sephora recently said it would close its seven Japanese stores, British retailer Boots PLC closed its Japanese operations last July. More recently, both Morgan Stanley and Societe Generale have announced plans to close their Japanese retail-brokerage business, and Fidelity Investments recently scrapped plans to build a call center in Japan.

To me, it smacks of corporate capitulation, one reason Japan has piqued my interest these days. Although I've long suggested bottom fishing is a loser's game, I am increasing my exposure to Japanese stocks, which even in the midst of such ugly fundamental news are actually outperforming U.S. stocks for the first time in years. Since the U.S. markets reopened following the Sept. 11 attacks, the advance in the Nikkei 225 has outpaced that of the Dow or S&P albeit by a small margin. The fact that this bullish price action has been accompanied by a decline in sentiment is what makes Japanese stocks attractive.

As we've pointed out before, during the early stages of a real bull market, there's never a huge urgency to buy. Even when prices do rise, there is little interest among either individual or professional investors. The prevailing attitude isn't greed or even fear...but doubt. These days, the popular consensus is hopeful about U.S. stocks and doubtful about Japan reason enough in my book to believe Japanese stocks are likely to outperform.

And although buying Japanese stocks in the midst of such ugly economic news seems ludicrous, the trades that seem most "risky" are often the ones that offer the best risk-reward odds. After all, if the Dow managed to rebound to early 2000 levels, it would increase about 16%. But if the Nikkei traded at 2000 levels, it would increase by almost 69%.

As we always say, it's not what you trade, but how you trade. Depending on your account size, there are any number of strategies to consider if, like me, you're bullish on Japan.

The most direct way to go long Japan would be simply to buy Japanese stocks, many of which trade in the U.S. as ADRs or American depositary receipts. Citigroup and Bank of New York have excellent sites with information about Japanese ADRs, and the SmartMoneySelect stock screener. will let you specifically sift for ADRs as well. Orix, Pioneer, Kyocera and Sega are among the ADRs I am considering for purchase at or above current levels.

For smaller accounts that need a more diversified option, there are a number of high quality mutual funds worthy of attention. Among Japan-stock mutual funds, which gained an average 113% in 1999, both Warburg Pincus Advisor Japan Small Company fund and Japan fund come with no sales charges, unlike two similar funds from Fidelity Investments.

The two exchange-traded funds that track Japanese stocks are iShares MSCI Japan Index fund and the more recently launched (and slightly cheaper) iShares S&P/TOPIX 150 fund. Both own familiar index-dominating names like Toyota, Honda, Nippon Telephone & Telegraph and Sony.

A slightly more sophisticated (and risk-averse) way of playing the Nikkei would be to purchase MITTS and I'm not talking about winter gloves. MITTS, also sometimes called equity-linked notes, are essentially bonds linked to an index or a basket of stocks. Like a warrant or call option, they're designed to limit your downside risk while letting you participate in the upside performance of a particular investment. There are a number of MITTS whose value is based on the Nikkei 225, including Merrill Lynch Nikkei MITTS 2005, Merrill Lynch MITTS and Merrill Lynch Nikkei 225 MITTS.

They are issued at $10 a share and provide 100% principal protection, so when the MITT expires, you're guaranteed to receive at least $10. In addition, the holder receives a percentage of the upside if the Nikkei moves above the "starting value." It's a hedged position that features some of the upside, none of the downside.

More sophisticated traders, especially those with the ability to use leverage, might consider setting up a spread trade. We first talked about spreads last spring in the context of closed-end mutual funds. Long used by commodities traders as a method of hedging risk, a spread is established by the simultaneous purchase and sale of two different but related securities. The purpose of trading a spread isn't necessarily to buy low and sell high, but to profit from the change in the relationship between the two securities.

Historically, the Nikkei has traded higher than the Dow, with a 17-year average of about 14,000 points. But since the early 1990s, that spread has narrowed considerably, and for a brief moment in September actually turned negative for the first time in 45 years when the Nikkei traded below the Dow. On a comparative basis, Japanese stocks aren't just cheap, but specifically cheap relative to U.S. stocks.

The spread to consider then, would be buying Japanese stocks while simultaneously shorting U.S. ones, anticipating that regardless of what happens in global markets, Japanese stocks are likely to outpace domestic issues. For example, shorting the S&P 500 Spiders against a long position in iShares MSCI Japan, isn't a directional bet on the market, but simply an anticipation that the spread between the two instruments will narrow. As of early December, the spread is at approximately 105, while it was roughly half that during the mid-1990s.

On an individual stock basis, you might consider shorting U.S. benchmark General Electric against a similarly sized long position in Sony. That spread, now approximately 9, traded at over 24 when the Nikkei peaked in the late 1980s.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management. At the time of writing, Hoenig's fund held both long and short positions in many of the securities mentioned in this article.