Japanese stocks may at last be a good bet

Serious Money:  The Japanese stock market has witnessed several false dawns over the last 15 years - at least three according to most observers, but there may well have been more - with foreign investors, in particular, losing lots of money betting on a recovery.

Signs of a revival in corporate Japan have often been jumped on by investors. Money has poured into the Tokyo stock exchange, share prices have risen for a short while only subsequently, and often quickly, to collapse.

In the late 1990s, for example, Japanese equities recovered from lows reached during the Asian economic crisis as some improvement was seen in the incoming domestic economic and profits news flow.

It helped, of course, that stocks were booming globally. In early 2000 the Nikkei managed to break above 20,000 for the first time in three years. Some people thought the worst was now over and recommended buying Japanese stocks as the market was still way below the peak of around 39,000 reached over a decade previously.

What happened next is almost too painful to recount. As Japan slid further into its deflationary spiral, the Nikkei lost 60 per cent of its value, bottoming at around 7,700 in early 2003. Again, it didn't help that the rest of the world was experiencing a bear market at the same time.

Japan is always described as the one large stock market that is virtually uncorrelated with the rest of the world. Thus, because the Japanese economy has had unique problems, its stock market has tended to do its own thing.

And that has been to fall, more or less continuously, between 1989 and 2003. But the market has now been rising, like other global exchanges, since the start of 2003 and now stands at a four-year high. Could this, finally, be the start of the much-anticipated Japanese revival?

If so, with the index still barely above 12,000, surely there is plenty of scope for investors to get on board, notwithstanding recent strong gains?

The Japanese boom-bust story has played out over such a long period for a whole host of reasons. A lot of the problems originated during the bubble years of the 1980s when an asset price explosion ran out of control.

The most sinister aspect of that bubble was that it extended to both property and equities. Here in the West we have experienced both kinds of asset inflation, but not usually both at the same time.

Our markets and economies have recovered relatively quickly after house-price busts (in the early 1990s) and share-price collapses (the early 2000s).

The Japanese made things worse for themselves by making several serious policy mistakes. Fiscal policy was tightened at a spectacularly inopportune moment and interest rates were always cut by too little too late. Corporate Japan, weighed down by debt built up during the bubble years, was never given either the necessary carrots or sticks to restructure.

But lessons were learned and the authorities eventually figured out how to pursue a zero interest rate policy and a reform-minded (sort of ) prime minister was elected. Companies also learned some painful lessons and began to clean up their balance sheets.

Critically, operational performance of many Japanese businesses has also improved as managers learned that profitability is important. Corporate profits are currently riding something of a wave.

What happens next to stock prices depends almost entirely on this trend continuing.

Previous dawns proved to be false partly because of those policy mistakes. Although it would be foolish to rule out another such error occurring it seems unlikely. All the signs are that the lessons of the 1990s have been learned. More worryingly, the ruling political party, the LDP has always retained a strong anti-reform faction.

If the forthcoming general election sees these people regain any power then all bets on structural change will be off.

Other longer-term concerns centre on Japan's demographics: they are truly awful. But the optimistic way to spin this is to observe that the only way out is to grow more quickly. Otherwise, Japan will go bust, weighed down by past debts and an inability to meet future pension commitments.

So, is it time to put money into Japanese stocks? Like many others, I am guilty of making this call in the past, only to be badly burned. The emotional and financial scars of that experience inevitably colour any current decisions. But it seems to me that the accumulated evidence suggests that a small wager is warranted.

The election is a wild card so it is probably prudent to wait for the result. At the very least, careful attention to the opinion polls may pay dividends. The market is looking for any sign that the reformers, led by Prime Minister Junichiro Koizumi, will gain an increased electoral mandate.

Early signs are promising. Koizumi's approval rating is up 14 points compared to a month ago. Both the stock market and the yen have risen in the wake of the decision to call the election, which will help Koizumi's chances.

Investing in Japan raises the wider question of opportunities throughout Asia. These remain excellent in my view - Japan is merely joining the party, albeit rather late. And with most Asian equities there is, over the medium term, every chance of profiting from superior growth and a currency gain. Most regional currencies are likely to rise against both the euro and the dollar. Exposure to Asia has looked sensible for a while and one or two Japanese stocks should now be added to that portfolio.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.