Aging and ignored, Japan may be ready to rally

Commentary: Europe could aid a cheap, unloved market

No news is supposed to be good news, yet Japanese stocks have suffered more than other markets during the latest decline. The benchmark Nikkei 225 index fell 19% between late March and early June, about twice as much as American stock indexes and slightly more than indexes in Europe, the region that has consumed the world with dread.

The recent drop in Japan’s market is just that — one episode in a long stretch of dismal performance which began when a bubble that culminated a multi-decade postwar boom popped in the early 1990s. At that time, Japanese companies were thought to be paragons of profitability and effective management.

The bubble’s pop has kept the Japanese economy in or near deflation, despite interest rates that have been close to zero since long before it became fashionable among the world’s central bankers. A rapidly aging population has kept growth prospects down, as have the business regulations and stifling social traditions for which the country is justifiably renowned. Then there is China, which has usurped Japan’s role as the main Asian exporting nation.

No wonder Japanese stocks are close to multi-decade lows. And yet Japanese stocks trade at roughly 12 times earnings, more than the decimated markets of Europe but less than U.S. stocks. The dividend yield in Japan, where companies once were famous for their miserly payouts, is about the same as in the U.S. market and well above the yield on Japanese 10-year government bonds, or U.S. Treasury bonds, for that matter.

Moreover, the latest survey of global fund managers by Bank of America Merrill Lynch shows a strong aversion to Japan. Far more managers report being underweight than overweight there, even with Japan’s proportion of the global stock market much smaller than it used to be.

Getting a boost

Investors who have avoided Japan will point out no doubt that the market has been cheap and unloved for years and that the malign neglect has only grown. A rebound needs a catalyst. What might it be?

How about Europe? A revival in Europe could help Japan in two ways: Stronger growth would increase demand for Japanese products, and it’s also likely to reverse the long and deep slide in the value of the euro against the yen; after reaching about 170 yen per euro in 2008, the euro is worth about 100 yen today. A rising euro would make Japanese products cheaper for European buyers.

Even if Europe remains mired in its credit difficulties, improving fortunes in China, a big customer for Japanese industrial equipment, or the United States could stimulate Japanese exports.

Mutual fund investors who want to take a chance on a Japanese bounce have plenty of options. Among mutual funds, Hennessy Select Sparx Japan   and Matthews Japan   deserve consideration. Both funds, which get four-star ratings from investment researcher Morningstar Inc., are heavily invested in large companies in export-sensitive industries. They have managed to outperform the average Japan fund by 6.5 and 5 percentage points annualized, respectively, over the last five years, and stand to do even better in a more favorable macroeconomic climate.

Investors who prefer the low costs and easy trading of exchange-traded funds can try iShares MSCI Japan. Another option is Japan Equity Fund , a closed-end fund trading at close to an 11% discount to its net asset value, an indication of the pessimism toward Japan or perhaps toward stocks in general.

With valuations and sentiment so low, it’s reasonable to conclude that the Japanese stock market can get up off the floor if anything goes right in the world. For these stocks to fall much further, however, just about everything would have to go wrong. That seems to be the world we live in at the moment, but it seldom stays that way for long.