What the Crisis in Japan Means for Investors

We answer seven questions on the minds of many investors to help you protect your portfolio through these disastrous events.

1) I’ve already suffered through two bear markets in the past decade, and the return of volatility is scaring me. What should I do now?

If you’re worried, it’s time to reevaluate your investment plan. Start by asking yourself some questions:

• Are your assets divvied up based on your goals and your time horizon?

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• Is the money you have in stocks and stock funds dedicated for goals that are at least ten years away?

• Do you have adequate short-term reserves to handle emergencies and near-term wants and needs?

If you answered “no” to any of those questions, you may need to make some changes. If you don’t know how to do that, invest in a session with a fee-only financial planner. You can find one through the National Association of Personal Financial Advisors.

But if you’ve answered “yes” to everything, there’s just one more thing to consider. Has anything in your life changed that would change your financial goals or time horizon?

If not, the wise course is to leave your investments alone. Stock market volatility is normal and something you must shoulder if you want the inflation-beating benefits of growth-oriented investments. History tells us that markets recover from short-term crises, no matter how horrible they seem at the time. Consider: Stocks recovered from a 23% one-day plunge in October 1987 within two years. After 9/11, the Dow Jones industrial average’s 7% loss evaporated within two months. As long as the money you have invested in stocks is for long-term goals, you have the ability to withstand a drop triggered by a short-term crisis.

2) If the crisis focuses exclusively on Japan, why are stocks in the U.S. and other countries tanking?

First, the disaster has caused real economic disruption, and that will affect the amount of goods Japan buys from its trading partners. That means lower sales for companies that export to Japan and probably lower profits, so the declines in share prices are perfectly rational. The second factor is much harder to measure: panic. Until a crisis achieves resolution, investors tend to assume the worst and price stocks accordingly. In other words, they sell first and ask questions later. (See VALUE ADDED: Disaster in Japan Raises the Odds of a Double-Dip Recession.)

Is a big drop in U.S. stock prices justifiable? Not based on reasonable assumptions. Japan is our fourth-largest trading partner, after Canada, China and Mexico, and accounts for 5.4% of our imports and exports. That’s one-third of the amount of our trading relationship with Canada. Even if Japan’s economy contracts slightly in 2011-- what many consider a worst-case scenario -- the impact on the U.S. economy will be slight. (See PRACTICAL ECONOMICS: Japan's Disasters Pose a Slight Risk to the U.S. Economy.)

On the flip side, many U.S. firms compete head-to-head with major Japanese companies in such things as cars, heavy machinery and all sorts of high-tech gadgets. U.S. exporters in many areas could gain ground at the expense of Japanese rivals.

3. Are we at the start of a correction -- or, worse, a bear market?

The truth is, nobody knows for sure. With the stock market having essentially doubled in two years prior to the current selloff, it was certainly due for a correction (generally defined as a drop of 10%). But whether we reach that threshold or whether the present downturn turns into a full-blown bear market (a drop of 20% or more) depends on the economic fallout of the disaster.

The chances of a bear market rise considerably if the tragedy triggers a recession in the U.S. And that will depend, in great measure, on the course of the Japanese economy. Keep in mind that goods are not always simply sent from one country to another. For example, components bought from Japan by China may end up in products, or components of products, that are shipped to many other countries. If Japan’s general economic shutdown continues for more than a few weeks, it could crimp the supply chain and so global trade.

4. What kinds of companies are most hurt by this disaster, and which companies will benefit?

Estimates for insured losses for earthquake-inflicted damages alone range from $15 billion to $35 billion. One health and life-insurance company that will feel the brunt is Aflac (AFL, $50.89), which does 75% of its business in Japan. But reinsurance brokers (companies that sell insurance to insurance companies), including Aon Corp. (AON, $52.73), Willis (WSH, $38.97) and Marsh & McLennan Companies (MMC, $29.92), are poised to benefit because of potentially higher demand for reinsurance. (All share prices and related data are as of the March 15 market close.)

The energy sector is volatile, with damage to Japan’s nuclear facility producing a huge backlash against companies having anything to do with nuclear power. For example, shares of Cameco Corp. (CCJ, $32.57), a Canadian uranium miner, tanked 13% on March 14, the first full trading session after the disaster struck. But traders may have unfairly punished engineering-and-construction firms, such as Babcock & Wilcox (BWC, $30.82). It may be a good long-term buy. And a lot of money will be spent on rebuilding Japan, to the benefit of companies that make heavy machinery, such as Caterpillar (CAT, $100.75) and Cummins (CMI, $99.93).

Oil prices, which had been soaring over concerns about possible production disruptions in the Middle East, tumbled as traders calculated the loss in global demand from Japan’s reeling economy. But oil, as well as coal and natural gas, will benefit as Japan replaces nuclear-generated power -- and as it rebuilds. Check out oil-service giant Halliburton (HAL, $44.01) and coal producer Massey Energy (MEE), $60.93).

Don’t chase solar stocks, soaring on the nuclear scare. They’re bound to come back to earth in a month or two, then will likely rise (or fall) with oil prices. Two to consider after gravity kicks in: First Solar (FSLR, $158.91) and China-based LDK Solar (LDK, $12.66).

But Japanese consumers may respond to the tragedy by pulling in their horns, and that would hurt sellers of luxury goods, such as Coach (COH, $52.02) and Tiffany & Co. (TIF, $57.68). They derive 20% and 19% of their sales, respectively, from Japan.

5. What about my international funds? Should I sell those that hold a lot of Japanese stocks?

If you hold a pure Japan fund -- say, iShares MSCI Japan (EWJ) -- you’re undoubtedly a card-carrying contrarian. That’s the most-logical explanation for why anyone would make such a big bet on one of the world’s most-lethargic stock markets over the past 20 years. If that describes you, sure, hang on. If you liked Japanese stocks when the world merely avoided them, you should love them now that they’re universally despised.

Chances are, though, that you own Japanese stocks through a diversified international fund and that your stake is in proportion to Japan’s place in the world’s economy and stock markets. At last report, for instance, Dodge & Cox International (DODFX), a member of the Kiplinger 25, had 14% of its assets in Japanese stocks. Oakmark Global (OAKGX), a fine fund that invests in both U.S. and foreign stocks, had 21% of its assets in Japanese firms. Oakmark’s managers say that as far as they can tell, the disaster has had little impact on the “intrinsic,” or true, value of their Japanese holdings and may have even created buying opportunities. It would be foolish to sell a good diversified international fund that held a reasonable stake in Japanese stocks.

6. Treasury bonds have been appreciating since the disaster. Should I load up on them?

No. Don’t expect a repeat of the rollicking rally in government bonds that accompanied the near-collapse of the financial system in 2008. The disaster won’t stop the uptrend in jobs, construction and exports that helped push Treasury bond yields up (and bond prices down) sharply from October to February. Also, Japan may have to sell some of its $886-billion pile of U.S. bonds to pay for reconstruction. At best, Treasury yields might stay in a narrow range for the rest of 2011 before resuming an upward course.

7. What else makes sense for income?

Corporate and municipal bonds were better buys than Treasuries before the tragedy. They still are. And if there is a backlash against all things nuclear, beneficiaries should include natural gas, both domestic and the liquefied kind, that Japan needs to import. Yields on many energy-production and pipeline master limited partnerships top 6%, and their dividends are also secure from the Middle Eastern turmoil that will be in the news long after Japan begins to rebuild.