This article by Chris Gilchrist was published in The IRS Report in March 2011

Bulls and bears fight it out over Japan

Since the bursting of its credit bubble in 1989, Japan has been a graveyard for long-term equity investors. Rally has followed rally only to be followed by another slump in prices. The cumulative loss from the 1990 peak reached 79% when the Nikkei 225 touched its low of 7,300 in February 2009. Over those two decades, investors did make money in government bonds, despite their low yields, because of deflation - this was what strategist Albert Edwards first christened the 'ice age', which he still expects to hit Europe before long.

After being burnt in one or two of these rallies, most professional investors have remained resolutely underweight in January shares for most of the past decade. That's been a good call for long-term investors: it's easy to lose money trying to trade rallies. But in the last two years, thanks to appreciation of the yen, unhedged investors in Japan have done pretty well, with returns of 40% to 60%.

So could we see a bull market developing in Japanese equities? Invesco Perpetual's Paul Chesson was optimistic in early 2010 and is even more optimistic now. He views the 15% market gain from the November low as merely a correction from over-pessimism. He says in the current fiscal year (nine months of results out so far) on average corporate sales are up 9% and profits up 67%. Cost cutting has enabled even exporters to make more money despite a higher yen. The Topix index trades at marginally over break-upvalue and its dividend yield at 1.9% is the same as that on the S&P500.

JP Morgan strategists also like Japan, calling it "unloved, under-owned and cheap". They have upgraded Japan to overweight in international portfolios, but are keen to avoid booking a place in the Japanese graveyard and describe this as a "trading opportunity".

Martin Currie's Claire Marwick says "Valuations are supportive right across the market place". Neptune recently re-confirmed its faith in the big exporters - and reported that it had put on a currency hedge since it expects the yen to fall, which would be strongly bullish for shares.

But few fund managers now bother to talk about Japan when discussing global portfolios. They typically hold under 5% of their money there. That's one good reason to be interested, especially since evidence suggests there has been a big increase in foreign buying of Japanese equities in recent months. Unlike the US, where managers are usually happy to tell investors they are positive and are buying, most managers are reluctant to admit they are buying Japanese stocks. I rate this kind of quietly creeping bullishness as a good buy signal.

The big negative is that Japan's fiscal position is so dire it makes the US look virtuous. One-fifth of all government revenues go to debt repayments. Total government debt is 20 times revenues (that is 7 times as high as the US ratio that has Republicans frothing at the mouth).

Fears that the government simply cannot finance more borrowing could prompt a yen sell-off and rising interest rates. But with corporations flush with cash, that isn't necessarily a negative for stocks. Sterling devaluation was often good for UK shares in the 1970s and 1980s.

Funds investing in Japan are hard to select. Year-to-year performance has been erratic with few managers displaying consistency.

Both Axa Framlington and Baillie Gifford have good records in smaller companies. If a real bull market develops these are likely to do well, but they are highly volatile and heavily exposed to domestic companies. Invesco Perpetual, GLG and M&G all have creditable open-ended funds with a more general investment remit.

The investment trusts have all seen discounts narrowing in the past year; they are currently at about 12% for JP Morgan and Schroder and a mere 2% for Shin Nippon. Almost all these funds have run unhedged until recently and so have benefited from the rise in the yen against sterling.

I have holdings in JP Morgan Japan Investment Trust, JP Morgan Japanese Smaller Companies Investment Trust, Baillie Gifford Shin Nippon Investment Trust and GLG Japan Core Alpha.

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Chris is the editor of The IRS Report every month

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