The world has fallen out of love with Japan and Japan with the rest of the world. Aside from discussions with Japanophiles - who wax with justifiable lyricism about the country's efficiency, marvellous cuisine and exquisite sense of beauty - mention of the country these days is likely to provoke a raised eyebrow or a gently suppressed yawn. Investors regard Japan as resistant to their attempts to spread the gospel of shareholder value and a place where a bull run is when equities rally to one-quarter their 1990 level. Such is the lack of interest that one Tokyo-based broker toyed with the idea of removing the word "Japan" from the title of his investment notes in order to lure more clients into reading them.

Meanwhile, Japan looks at the outside world with a certain gloomy detachment. It feels vindicated that it did not swallow the wilder notions of unfettered market capitalism, and yet let down that its export-dependent economy nevertheless suffered an even sharper contraction than its reckless rivals. It regards with nervous resignation a rising China that will shortly displace it as the world's second-biggest economy, and long ago trumped it as a diplomatic and geopolitical power. It even looks on with a degree of envy at South Korea, a former colony whose industry is fast catching up with its own and whose society has largely proved more adaptable to changes wrought by globalisation.

At home, only eight months after an opposition party finally wrestled power from the crusty Liberal Democrats, disillusion has set in. What some dared hope was a modern Meiji Restoration has turned out to be rather less inspiring. There is already chatter about when Yukio Hatoyama, the "revolution's" leader, might resign. Economically, and in spite of this week's formation of a ruling-party faction that favours inflation-targeting, the country's leaders nourish a fatalistic acceptance of deflation. True, 15 years of more or less continuously falling prices have not triggered the crisis some predicted. But falling nominal output has accelerated Japan's relative economic decline.

There are important countervailing trends. Apart from when its Imperial Army was rampaging around Asia, Japan has, in some senses, rarely been as plugged into the world. Businesses have concluded their future lies abroad. Nomura snapped up the Asian and European arms of Lehman Brothers in a bid to become a global investment bank. Daiichi bought Indian pharmaceuticals company Ranbaxy in a bold (read expensive) international foray.

Japan's cultural influence abroad has probably never been greater. Tokyo is far more international than it was a decade ago. The capital city is even becoming easier to get to now that some international flights are being transferred from the wilderness of Narita to the relative convenience of Haneda airport.

Yet many Japanese seem more at ease with the idea of stately decline and genteel isolation. One of Japan's most popular books in years, The Dignity of a Nation , even suggested Japan should stop teaching its children English and withdraw from the world trade system altogether. Short of such radicalism, many people ask what is wrong with being a backwater of wealth and civility in an out-of-kilter world.

David Fuller's view During the first half of my career to date, I saw Japan morph in just over a generation from a small emerging market exporter of trinkets to an industrial powerhouse and state-of-the-art manufacturer of precision instruments. It seemed as if Japan could take over any manufacturing industry that it chose to target. Japan's corporate elites became richer than anyone else in the late 1980s, ate more fish, lived longer and appeared to be smarter. This dramatic economic transition produced what arguably remains the world's biggest ever property and stock market bubbles. In 1989, the Emperor's 284-acre Imperial Palace grounds were estimated to be worth more than the entire State of California and the capitalisation of Tokyo Stock Exchange briefly exceeded that of the entire US stock market. No economic challenge seemed too great for Japan.


During the second half of my career to date, I have seen Japan unwind its bubbles and struggle with recession and the world's longest deflation in living memory. Looking at the Nikkei's historic chart above, I am struck by the symmetry in terms of the time cycles of two secular trends, up and down. For investors taking a long view, the important factor is the valuation contraction confirmed by this chart of Japan's Price to Book Ratio for the Nikkei 225. Although we do not have data for the pre-bubble phase, you can see the levels commencing in 1989, when Price to Book peaked near 5.73, compared to 1.44 today and 0.82 at the March 2009 low. Price to Book is even lower for Japan's TSE2 (Second Section) at 0.71, as Eoin illustrated and discussed on 9th April.

None of this ensures that Japan's stock market performance will be transformed from underperformer to outperformer in the short to medium term. While valuations can certainly support a significant catch-up move for Japanese equities, this requires a change in sentiment by both Japanese and foreign investors, who have been left at the alter of failed medium-term recoveries on too many occasions commencing with the 1992 low.

Sentiment towards Japan's stock market is starting to improve, but none of us can be sure that this is the beginning of a sustainable recovery. I prefer to regard Japan as a contrarian play, where the safest strategy may be to have an opening stake and to accumulate more on easing, taking a long-term view. Previous disappointments make it more likely, not less likely, that Japan stock market will surprise on the upside over the longer term. Japan's demographics do not concern me because it has a high-tech rather than labour-intensive economy. Currently, Japan's stock market is technically overbought on a short-term basis and has commenced a consolidation. A technical rally by the yen is also a temporary headwind.