Brace yourself for Japan's earnings season

There's a joke making the rounds: If weary-eyed economists want to wake up in the morning, they needn't reach for the coffee -- just Japan's latest economic statistics. No way you'll sleep after perusing them.

Stock also may be able to boycott java in the weeks ahead. It's doubtful some will be able to sleep after seeing Japan's corporate reports.

They could be decidedly ugly, refocusing attention on the deflation and malaise eating away at Corporate Japan. The Nikkei may be in for some rocky, rocky days.

"The problems over the next few weeks will not be the bad news about the economy, but rather the business implications of a bad economy," says Carl Weinberg, chief global economist at High Frequency Economics.

Fitch offered a grim assessment of Japan's fortunes, warning Tokyo may have to reschedule debt or print more yen to avoid default.

The views, expressed by Fitch President Stephen Joynt, were in response to Tokyo's recent request that ratings agencies explain why they're rating Japan so low.

Given tone of Fitch's rebuttal, Tokyo may be regretting that action. "In the absence of corrective action, Japan could be caught in a debt trap from which it can escape only through monetization or default," the letter said. Fitch rates Japan a third-ranking "AA." Oddly, recent weeks have seen a barrage of Japan's-economy-is-bottoming articles in the press and from analysts. Salomon Smith Barney Inc, for example, increased Japan's weighting in its global stock portfolio at the expense of the US and Europe.

Matthew Merritt, the firm's global equity strategist, thinks a recovery in the world's No. 2 economy may be in the works.

Now for a reality check. Observers in general don't think the economy is recovering -- just that it's not unraveling as fast as it was six months ago.

The Bank of Japan's so-called Tankan report -- which showed business conditions aren't worsening -- is responsible for much of the optimism.

In reality, though, Japan's business climate is pretty dismal. More than three-quarters of small companies and two-thirds of big ones are reporting anemic activity, at best. To Weinberg, "this means we should also expect companies' annual reports to stink, both absolutely and relative to expectations."

Far slowing the rising number of corporate failures, that outcome could accelerate the trend. Moreover, if the Nikkei 225 stock average takes the news badly and slides, Japan's fragile banks also get weaker. Banks have watched shares on their balance sheets dwindle in value for years. Rather than sell them and take the losses, they've hoped the Nikkei would rebound and bail them out. Instead, stocks have lost further ground.

While barely made a dent, banks have increased the rate at which they're writing off bad loans, especially in the second half of the fiscal year. That means that banks' income sheets will be hit by the cost of writing loans off plus the drop in loan revenues. But the real problem is the Nikkei's slide and how it's weighing on the sector.

Banks, Weinberg reckons, haven't been reporting the full impact of their losses resulting from bad loans. The same may have been true when they marked their long-term equity holdings to current market value in midyear financial statements.

The fear is that loss estimates reported by banks for their fiscal first half, ended Sept. 30, were more manageable than accurate. Executives may have done so hoping the stock market would improve in the second half of the fiscal year. Then, they wouldn't have to confess to being insolvent at midyear. With the benchmark Nikkei 225 stock average at 9,775 on Sept. 30, many banks indeed should've reported themselves insolvent.

With the Nikkei unable to move much higher, full financial statements for the fiscal year ended March 31 will have to be reported. The cover-up of huge equity losses will be much harder, if not impossible. Some institutions may have to report themselves as not only broke but also guilty of grossly and intentionally understating losses, Weinberg says. Thus, we're likely to see a big rush to cover up the cover-up as banks unveil their reports.

Regardless what happens with banks and the stock market, Moody's Investors Service may be ready to make good on its threat of a two-notch downgrade for Japan. If so, it also may lower credit ratings for individual banks. Additional downgrades could make it harder for banks to do business with other institutions, hitting their stock values, too.

The yen's sudden rise isn't exactly helping. Rather than enacting painful economic reforms, Prime Minister Junichiro Koizumi and his team have talked down the yen. The hope was to make Japanese goods more competitive so the nation could export its way out of recession. These days, even with Japan's problems, it's the US dollar that's trending lower. It's changing hands at 128 yen versus 132 at the start of the year.

These two trends -- falling stocks and a firmer yen -- could be good news for Japanese government bonds. Even with the specter of rating downgrades hanging over the market, local investors may have little choice but to buy debt.

With yields so low -- 10-year rates are 1.365 percent -- few analysts expect a big rally, but bonds may be a safer bet than stocks this earnings season.