"Japan's amazing ability to disappoint," read a headline in The Economist as the country struggled to rescue its insolvent banks in the late 1990s. More than a decade later, it still seems to be letting investors down with rally after rally that runs out of steam and ends in new lows. By now, the market is "undeniably cheap", says Richard Newell in Investment and Pensions Asia. But with many false dawns still fresh in investors' minds, "how can they be sure that this time will be different"?
Even local equity analysts, who should have the most to gain from finding silver linings, seem to be struggling to keep the faith. "We find it hard to paint the scenario of another sharp fall," says Citigroup's Tsutomu Fujita. But "little by little, we fear the market is turning into something more and more difficult to figure out on the basis of economic rationality".
Many investors are certainly shell-shocked by the implosion of the economy; GDP contracted at an annualised rate of 12.1% in the fourth quarter of 2008 and looks likely to have been even worse in the first quarter of 2009. Most of that's due to collapsing trade, says Kazuo Ueda in the Far Eastern Economic Review. Although the ratio of exports to Japan's GDP is less than many investors think (16%), export growth contributed 67% of GDP growth in 2003-2007.
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What's more, Japanese manufacturing is dominated by cyclical industries, such as autos and goods for business investment, making the economy especially vulnerable to busts like these. Still, "one comfort of all this analysis is that when strength returns to the global machinery industry, Japan will be sure to experience a V-shaped recovery".
That may come more quickly than most think, says Julian Jessop of Capital Economics. "Exports have already levelled out and even the smallest bounce from here would have a positive contribution to growth." Surveys show firms expecting to raise output in April and May, so the economy "could start to grow again as soon as the current quarter". For 2010, he expects growth of around 2%, "comfortably ahead of the rest of the G7" although this is by no means a consensus view among economists.
It may be too optimistic to expect such a quick recovery. But for value investors, Japan has one major draw: "maximum pessimism", says James Montier of Socit Gnrale. While recent news looks like "economic Armageddon", valuations have been hammered down to reflect that. The Topix benchmark is trading on a price/book value (p/bv) of 1.11. Japanese small caps are "one of the world's cheapest asset classes", bottoming in March on a p/bv of around 0.7.
For Japanese investors, equities are now more attractive that Japanese government bonds (JGBs), says Christopher Wood of CLSA. The yield on the Topix is 3%, compared with 1.4% on the ten-year bond. At these prices, he would be "scared to own" JGBs, given that another 44.1trn (9% of GDP) is set to be issued this year.
Income-seeking investors would be better served by real-estate investment trusts (J-Reits). A credit crunch and the failure of the New City J-Reit has left the sector depressed, but recent government moves to support them suggest no more are likely to go bust. With many now on double-digit yields, this is one way to play a Japanese recovery. One way in is via the Next Funds Reit Index (JP:1343) exchange-traded fund, which tracks the Tokyo Stock Exchange Reit index.
