Is Japan really back?

The mainstream media and institutional investors are all going wild for Japan, says Chris Mayer in The Daily Reckoning. And there certainly seem to be strong indications that economic conditions are improving. But can something so popular really be a good investment?

When Rakuten, Japan's largest online shopping mall, quietly acquired a piece of the Tokyo Broadcasting System and announced its intention to merge TBS in Rakuten, it created quite a stir in the Land of the Rising Sun.

This sort of thing was not supposed to happen in Japan. Instead, a kind of forced stability was the hallmark of Japan's economy. It was supposed to be devoid of the more freestyle elements of Anglo-American capitalism, such as takeovers and mergers. But that era is over.

The Japanese stock market was once the greatest show on earth. America, indeed the world, couldn't get enough of Japan. Books extolled how Japan was primed to take over the world. America, these pundits predicted, would soon be a poor vassal in a new Japanese Empire. Come to think of it, you hear arguments along the same lines made today about China.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

But after the peak in 1989, the curtain fell, and it's been largely riding the skids since. The Nikkei Stock Average fell to a low of 7,831 in April 2003, a drop of 80% from its high. That seems to have marked the bottom.

Since then, it's slowly crawled out of that hole. Today, it sits at around 13,199 - near four-year highs and a 68% gain from the bottom, but well below the old peak of 38,915.

I first wrote a bullish piece on Japan in my US newsletter, Capital & Crisis, in April 2004. Since then, the Nikkei has rallied and Japan has been in the news more often. A recent cover of The Economist read: 'The Sun Also Rises'. Trading volume in Japan has surged, reflecting an influx of money looking for a stake in Japan's recovery - everybody from European pension funds to flush Middle Eastern oil barons.

Normally, I wouldn't get excited about something so hashed out in the mainstream media. But it's hard to ignore the world's second largest economy. And we may come to different conclusions for investment purposes.

Our question is this: Is Japan's revival real, or are the seemingly bullish sentiments on Japan premature? To offer a preview, I lean more toward the former. Let me show you the collected evidence, which I believe offers a compelling portrait of an economy on the mend.

The most important changes are those happening on the ground - in individual companies, industries and the banking system.

Consolidation of Japanese industry is only one part of the story. The excesses of the prior boom have finally sweated off, like the soft middle of a man newly taking up exercise. In its place, a leaner and more competitive economy is emerging.

Once saddled with bad debt and deadbeat borrowers, Japan's banks have cleaned up. Today, bad loans are half of what they were in 2001. As a result, Japan's banking system is ready to expand again. For the first time in seven years, lending in Japan is up, a clear sign that economic conditions are improving.

The real re-emergence is also evident in places like Nagoya, the heart of industrial Japan. The old sunset industries like steel, ceramics, autos, machinery and chemicals are booming.

How does high-cost Japan compete with low-cost China? Easy. It doesn't. Japan has moved up the food chain, producing sophisticated high-end products - things like hybrid car engines and robotic machinery for industrial use. So far, South Korean and Chinese manufacturers have been unable to mimic Japan's technological savvy. In fact, some of Japan's biggest customers are other Asian manufacturers.

Then, too, there is the incredible efficiency of Japanese firms. Only in Japan could the construction of a new airport finish two months early and $1 billion under budget, as recently happened in Nagoya.

Bears on Japan fret about the aging population, as if Japan could run out of workers. Taken to laughable extremes, Japanese demographic forecasts point to an ever-diminishing population such that there will only be three people left by the year 3000. These kinds of projections never come true, because demographics change - albeit slowly. Already, Japan is finding workers from overseas. Employers are increasingly hiring migrants from places like China and Brazil.

Bears may also point to Japan's reliance on foreign oil - it imports nearly all of its oil. This is true, but the point misses the larger picture. Japan's reliance on oil has fallen. As recently as 1991, oil supplied 57% of Japan's energy. Today, it stands at 49% and is heading lower. Japan has turned to alternatives such as nuclear power, coal and natural gas. Even so, the Japanese are much more efficient in their consumption of energy. On a per capita basis, Japan's energy use is about half that of the United States.

Another source of nagging doubt about Japan's stock market outlook: The locals have not yet bought in. Japanese households invest only 8.5% of their assets in Japanese shares. Figuring the locals know better, some use this as evidence that the West is being duped.

Ironically, though, locals can sometimes be the last ones to recognise what's happening, especially after so many years of disappointment. Look at South Korea. That market has soared 24% this year, among the best in the world. Yet only 6% of Koreans own shares in the Korean market. Only recently has Korean ownership of Korean shares started to increase.

As Christopher Wood, the chief Asian equity strategist at investment bank CLSA, notes, 'The longer the Japanese domestics do not buy, the more inevitably they will buy. And when they do, they will do it all at the same time.'

In short, the lack of domestic buying is another catalyst to take the market higher.

By Chris Mayer for The Daily Reckoning

Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr Mayer's essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of CrisisPoint Trader and Capital and Crisis - formerly the US Fleet Street Letter.

For the team's latest UK forecasts, readers can click through to this special report now: