The japanese bull appears to have finally come out of its long, deep slumber, creating optimism that the country’s stock market is poised for a sustainable takeoff.

Buoyed by a recovering economy; improvements in domestic employment, income and capital expenditure; an upbeat property market; and rejuvenated political will, the world’s second-largest economy may be poised to regain the lustre it lost 15 years ago.

Since collapsing in 1990 on the back of structural inefficiencies, bad loans, corruption scandals and crashing stock and property markets — followed by deflation, high unemployment, weak consumer spending and soaring public debt — Japan has endured three recessions and several false starts in its recovery.

The false starts produced sharp spikes in the Japanese market in 1992-93, 1995, 1998-99 and late 2003 and early 2004. None of these rallies was sustainable. But now, for the first time in almost 15 years, investors have managed to hold on to profits for more than a year.

They also expect to incur further gains as momentum continues to build. On Oct. 7, the Nikkei 225 stock average index closed at 13,228, up 16% for the past year and more than 70% above its April 2003 low. it was, however, far short of its December 1989 high of almost 39,000.

“Japan is finally over the hump,” says Chuck Bastyr, managing director and portfolio manager in BPI Global Asset Management’s Toronto office. Japan’s economy, stock market and political and corporate environment are all moving in the right direction, he adds.

The Japanese economy is in good shape, growing at an annual rate of 3.3% in the second quarter ended June 30. Strong demand from overseas markets, especially China, for Japanese machinery and components have boosted revenue for Japanese companies. Those that have already cut costs are experiencing higher profit margins as a result, which, in turn, has allowed them to pay down debt and increase capital investments.

“For the first time in more than a decade,” Bastyr says, “we’re seeing loan growth.
Companies are starting to invest again, profits are increasing, property prices are rising and foreign investors are fuelling the stock market. This is indicative of the momentum that is starting to build in Japan.”

Mark Grammer, vice president of investment at Mackenzie Financial Corp. in Toronto, is also positive. “The private sector has become more efficient, profits are at an all-time high — increasing by 16% last quarter,” he says. He also contends that profits are “much cleaner and healthier than at the 1989 peak, revenue looks more sustainable than it has for a long time and free cash flow is at a record high.”

In addition, he says, “There is a demonstrated improvement in policies, representing a shift from traditional Japanese policies. Managers are younger, more effective, more accepting of Western principles in running their businesses and more shareholder-friendly.”

More recently, the improved sentiment in Japan is probably, in large part, because of continuing economic reforms. Prime Minister Junichiro Koizumi, Bastyr says, has been given a mandate to reform the economy following his ruling Liberal Democratic Party’s resounding victory in the country’s snap elections held in September.

“It is the quantum event that supersedes the subtle changes that have taken place over the past few years,” Grammer adds.

Koizumi called the unprecedented snap elections after the House of Councillors rejected the government-sponsored privatization of Japan Post (reputedly the world’s largest financial institution, controlling more than US$3 trillion in household assets).
The prime minister’s move was uncharacteristic in Japanese politics, as he risked his job in an effort to reduce the state’s role in the economy.

Koizumi’s victory marked a turning point in Japanese politics, representing a “changing of the guard from old to new,” says Grammer. “It will also reduce the pork-barrel politics that is prevalent in Japan.”

In a speech to the Japanese Diet after his victory, Koizumi vowed to push ahead with reforms. They have been gradual but cumulative over the past decade, in areas such as financial regulation, corporate and labour laws, capital markets and corporate governance. The government is expected to reform government-related financial organizations, the social security system and the fiscal structure, and reduce the number of civil servants.

“Koizumi will also re-table mergers-and-acquisitions legislation, allowing the use of stock to acquire companies,” Grammer says. “This will be the final catalyst for a sustainable bull market.”

@page_break@With a host of favourable micro and macro factors beginning to have a positive impact on Japan, investors should benefit from this sustainable cycle. Grammar notes multiples have contracted, and most individual and institutional investors are currently underweighted in Japan. “However, that is set to change,” he says. “Based on a global comparison, Japan is very attractive and will experience a flood of foreign money.”

Privatization of the postal system should free up savings, a portion of which will find its way into the stock market, Grammer adds. Domestic participation will increase significantly, driving the market higher.

Both Bastyr and Grammer see opportunities in reflation plays, including financial services, real estate and retailers. “The banks will be major beneficiaries of the pick-up in real estate and loan growth,” Grammer says. “And consumption of durables and non-durables will rise.”

As a result, growth will be domestically driven, reducing traditional dependence on the export sector.

Valuations in Japan are reasonably good, acknowledges Chuck Wong, vice president and portfolio manager at Toronto-based Dynamic Mutual Funds Ltd. , but he believes better opportunities exist in other Asian markets. “From a top-down perspective, Japan looks positive,” he says. “But, looking at the region as a whole, there is better value outside Japan at similar companies with more attractive fundamentals.”

A bottom-up stock-picker, Wong says Korean companies Samsung Electronics and Hyundai Motor Co. are relatively more profitable and cheaper than Japan’s Sony Corp. and Toyota Motor Corp., which operate in the same space.

Wong isn’t alone in his reticence. The Organization for Economic Co-operation and Development says Japan faces economic challenges — which could threaten the sustainability of its economic and market recovery. The OECD forecasts an average annual growth in gross domestic product of only 1.3% for the remainder of the decade.
This is largely because of poor productivity growth and an aging population, which
increases health-care costs and adds to the burden on the public pension system.

On the political front, Koizumi’s term expires next September. Although it is unlikely the changes in Japan will be reversed, it will be left to Koizumi’s successor to continue the reform process. However, there are indications that his party will ask him to remain at the helm. According to the Oct. 13 issue of Greed & Fear, Credit Lyonnais Securities Asia’s weekly newsletter: “There is a growing possibility that Koizumi will not depart the scene next September. But he will have to be seen to be asked to stay.
Koizumi still has an appetite for reform. Chances are increasing for real supply-side reform in Japan, which is incredibly bullish.”

The reform process and reducing the state’s role in the economy will remain challenges for Japanese politicians. However, “the spiral has been broken,” says Grammer. “All the cards are in the right place, putting Japan in a position to move to the next phase.” IE