It seems like déjà vu. un-til May, Japan’s stock market was enjoying a relatively good run and its economy appeared to be picking up steam. But, as has been typical since the early 1990s, the apparent strength of the world’s second-largest economy turned out to be unsustainable.

Yet, views are mixed on what Japan has in store, ranging from subdued optimism to veiled pessimism.

“Japan has had a lot of false starts,” says Mark Grammer, vice president of investments with Mackenzie Financial Corp. of Toronto and lead manager of Mackenzie Universal Global Future Fund. For almost two decades, he adds, investors have, on average, made money in Japan in short spurts of about six months to slightly more than a year, then lost money for as long as three years.

Investors, therefore, should proceed with caution: many of the ills of the recent past linger and there are no concrete reasons why this time should be any different.

To sum it up, Grammer says he is cautiously optimistic but “not wildly excited” about Japan.

Sam Baldwin, portfolio manager of global investments with Guardian Capital LP in Toronto, is also on the side of subdued optimism: “Japan is past the worst of ills.”

For quite some time, few Japanese companies have popped up on Baldwin’s “buy” list; but, recently, more companies are showing up. Nonetheless, he, too, is cautious, as the rewards of investing in Japan are “not piling up” relative to the underlying risk.

A May 29 report by Hong Kong-based brokerage/banking/private-equity firm CLSA Asia-Pacific Markets is selectively optimistic: “Investors should aggressively continue buying Japanese banks, insurers and brokers, and also look for blue-chip Japanese equities trading near five-year low price/book multiples.”

The report adds that even if Japan is experiencing another false start, “downside is limited.”

On the pessimistic side, Don Reed, president and CEO of Toron-to-based Franklin Templeton Investments Corp. and lead manager of Templeton International Stock Fund, sees “no value” in Japan right now.

Ever since the Japanese stock market fell from its peak in February 1989, it has failed to regain its lustre, leaving jilted investors on the sidelines time and again. Instead, the market has experienced several sharp spikes in prices, spurred by myriad factors, including intermittent signs of recovery in the struggling economy; improvements in domestic employment, income and capital expenditure; buoyancy in the property market; and renewed commitments to political reform.

In between rallies, the Japanese economy has endured three recessions, an extended period of deflation, relatively high unemployment, weak consumer spending and escalating public debt — all of which have undermined a sustained market recovery and dampened investor enthusiasm.

This year has been no different. Since May 30, when the MSCI Japan index reached its highest monthend level for the year, at 3048.2, it has fallen by more than 10% to 2741.7 as of July 31. For the seven-month and one-year periods ended July 31, the MSCI Japan index was down 9.7% and 16.2%, respectively, in U.S.-dollar terms, but remains in positive territory for the three-, five- and 10-year periods, with returns of 5.7%, 10.1% and 3%, respectively.

Comparatively, the MSCI U.S. and world indices have fared worse for the seven-month period — with losses of 13.2% and 14%, respectively — as well as for the three-,
five- and 10-year periods. The U.S. index is up 1.2%, 5.3% and 1.2%, respectively; while the world index is up 4.8%, 9% and 2.4%, respectively, during those time periods.

Arguably, the Japanese market has been resilient in the face of the U.S. slowdown and the global financial turmoil precipitated by the subprime mortgage crisis. “Japanese banks didn’t get stuck with huge subprime losses,” says Reed, noting that this has been positive.

And the International Monetary Fund’s July 21 executive board report on Japan states: “The fallout from the global market turmoil [in] the financial system has been limited” and exposure “remains well within banks’ operating profit and capital.”

That optimism about Japan’s recovery, albeit subdued, came from a number of sources. Japan’s economy recorded surprisingly strong growth in the first quarter of 2008, based on preliminary economic data. Real gross domestic product growth — fuelled by exports and private consumption — accelerated by 0.8% in Q1, up from 0.6% in the previous quarter. But while this translates into a robust expansion of 3.2% in annualized terms, the reality is that this growth rate was based on revisions to 2007 fourth-quarter results — to 0.6% from 0.9% — providing a lower base for comparison.

@page_break@Another positive sign was the return of inflation, which CLSA considers “the single most important change in Japan for more than a decade.”

This, Grammer says, will result in a shift from savings to equities in the country’s negative real interest rate environment and a pickup in consumption as consumers bring forward planned purchases of durable goods to avoid erosion of purchasing power. Consumer price inflation, which has climbed steadily this year, is now in the annualized range of 2%, while the Bank of Japan has held its benchmark interest rate at 0.5% since February 2007.

Exports were also robust in 2008 Q1, with many Japanese companies and industries benefiting from the so-called “Chinese Viagra” phenomenon. Many Japanese-owned plants in China, especially in the capital-goods sector, have taken advantage of lower labour costs, says Erik Nilsson, senior economist with Bank of Nova Scotia’s international research group in Toronto. He adds that these companies will continue to do well, but advises: “You have to keep in mind that a significant amount of Japanese products exported to China is for assembly.”

But that optimism from Q1 has since turned to pessimism. In June, the Japanese government downgraded its outlook for the domestic economy due to slowing global growth, soaring energy costs and rising raw material costs. The combination of these factors, it said, were negatively affecting industrial output, exports and corporate profits. However, it remains optimistic that the economy will recover moderately.

“We’re probably looking at growth potential of about 1.5%-2% for 2008,” Nilsson says, adding that a shrinking population and some cooling of economic growth in the U.S. and Europe, which together account for about 40% of Japanese exports, will limit the pace of expansion. However, he notes, Japanese intra-regional exports will remain healthy.

Scotiabank’s Aug. 1 Asia/Oceania Weekly Outlook states that the economic slowdown in Japan is becoming more deeply entrenched, and the erosion of household spending power resulting from job losses, stagnating incomes and rising food and energy prices will squeeze the retail sector, adding to the economy’s woes.

It seems Japan has once again lost its momentum. The jury is still out, however, on how long this slowdown will last. There are positive signs: Baldwin says that corporate governance is improving and dividends are growing, even though earnings per share are moving sideways. And more than half of the companies on the MSCI Japan index recently traded at below book value.

Grammer also sees positive signs, saying that Japan has a “lot of world-class companies.” He adds: “P/E multiples are at their lowest in 25 years, cash flows are going up and balance sheets are strong.”

Reed, on the other hand, says that on a relative basis, the Japanese market is “on the expensive side” and “it is difficult to find stocks.”

This is not the first time since 1990 that the sun rose in Japan but set quickly, without going through a typical cycle and leaving inves-tors in the dark. But if you were to look at the trend in the market, the sun may soon rise again. IE