Just when you thought you had your hands full with the current crop of investing fears – muni bond defaults, inflation, double-dip recessions, rising interest rates, the falling dollar, political unrest in the Middle East, rising oil prices, etc. – a new one appears: natural disasters. As we said in our article last month, Wall Street doesn’t see the real dangers coming…and generally doesn’t price in the unknowable risks of investing.

And unlike perhaps half of the current crop of investment fears, this one is serious. Japan is the world’s third largest economy. Until a few months ago, they were the world’s second largest economy, but a multi-decade stagnation has left what was once the hottest economic growth story a debt-ridden shell of its former self. You'd never have imagined in 1990 that Japan would look the way it did in 2010. And that was before  March 2011.

Stated another way, the Japanese economy is larger than all the countries that have caused market mayhem over the past few years combined. Iceland, Greece, Ireland, Egypt, and Libya together don't equal even 1/5th of a Japan, which tips the scales at approximately $6 trillion in Gross Domestic Product. 

If  we calculate economies in U.S. dollars, in all likelihood, Japan is once again the second largest economy in the world, partially due to recent strength in the Yen (although in theory, if the Chinese currency were valued by market forces, China might be much bigger than Japan.) And then tragedy struck the economy that needed no more headwinds.

Not to dismiss the personal tragedy of this current catastrophe, but plenty has been written on that subject elsewhere. Our immediate concern lies with our portfolios, and the implications of a once-in-a-generation (hopefully) natural disaster.

So how bad has the Japanese economy been for much of the last two decades? And how spectacular has China been? Well, in the early 1990s, the Japanese economy was about 10 times the size of China’s. In dollars, the Chinese economy surpassed Japan last year – one of the only major countries to stagnate economically. 

The manager of T. Rowe Price Japan (PRJPX), a fund we own for some private management clients and have recommended in our online portfolios, recently noted that only 47 Japanese companies are trading at higher market valuations than they did in 1990. At least the U.S. historic tech stock bubble from 2000 was followed by hot stocks like Google (GOOG) and Apple (APPL). Japan’s bubble pop had no second act.

But as serious as Japan's problems are , do they warrant such a drop in stock prices?

At this point (and this point is Nikkei 8,600), we believe the Japanese market is done underperforming other markets. The extra losses Japan has experienced over the past few days are tempered by the fact that the problem is largely Japan’s.  At this point, any additional troubles in Japan, or ensuing issues in  Japan's economy, could likely drag other stock markets down as well. Most markets can't handle a serious hit to the global economy without some correction of their own. 

Essentially, you now have Japan risk even if you don’t own Japanese stocks. To lower (but not eliminate) this risk of collective stock failure, investors can rely on relatively conservative portfolios with heavier U.S. large cap stock exposure, minimal emerging markets exposure, no commodity exposure, and healthy allocations to investment-grade bonds, notably longer-term treasuries, which were wildly decried as a bad idea just a few short weeks ago.

And you may own Japan stocks anyway. Certainly, our clients have exposure, largely through funds and ETFs, like Vanguard Pacific Index (VPL), that hold large stakes in Japan, and through some international funds (although, in general, we're running low international allocations compared to the middle of the last decade). Most non-emerging market international funds have a large stake in Japan, because the Japanese stock market remains a significant component in international benchmark indexes.

Based on the lows hit in recent Japanese trading (in the middle of the night on 3/15/11 EST,) the Nikkei index was down about 20% since the earthquake – worse than the 9/11 hit to the Dow, and about as bad as the 1987 Black Monday crash.

Japan now has a dividend yield slightly higher than the S&P 500 – quite a change from its 1990 peak, when the country was the investing hot spot sporting triple digit price-to-earnings ratios. I can't remember how long it's been since investors could earn more in dividends in the perpetually expensive Japanese market. Several decades at least. Maybe forever.

This is particularly noteworthy, as Japan is a country with a 10-year government bond yield of about 1.22%. In the U.S., our 10-year government bond, which many consider paltry, yields 3.3%, well above the sub-1.85% S&P 500 yield. In other words, if Japanese stocks go nowhere for the next 10 years, Japanese investors will likely do better in their stocks than in bonds.

Japan currently holds our highest fund category rating (tied with well-scorned financials), and has since before this tragedy. That's because Japan has been out of favor for years, and with the exception of a few strong periods, most recently from November 2009 to June of 2010, has performed poorly. We sold Vanguard Pacific Stock ETF (VPL) at the end of June 2010 in our Aggressive Growth portfolio.

Our category ratings go up (meaning we expect better performance going forward, relative to other categories) as a category of funds performs badly relative to others, and especially if investors are ignoring that area. To get an idea of just how ignored Japan has been, look at the fund selection. There are few available (naturally, many launched right near the peak of the Japan bubble in 1990,) and the open-end, actively managed funds are all under $1 billion in size. Fidelity Japan (FJPNX) tips the scales at about $500 million, and T. Rowe Price Japan (PRJPX) weighs in at about $200 million. The entire category has less money than just the largest Chinese ETF, iShares FTSE China 25 Index (FXI), which has $7.3 billion in assets, although iShares MSCI Japan Index (EWJ) has now reached $5.7 billion. People go where the action is – like tech in 2000. Note this author and some clients as of this week now have a position in EWJ.

We're currently adjusting our Japanese allocation – higher in most cases. We don’t know where the bottom is, or how bad the situation will get. But when we get a chance to buy a category that's attractively priced at significantly lower prices, we tend to buy. Maybe this isn't the bottom for Japan, but markets tend to overcorrect. If Japanese stocks decline much further, other markets are going down for the ride. 

No one wants to head into a burning building, but it tends to work in investing.