Is it time to quit Japan?

Was last year's strong performance on the Japanese stock market yet another false dawn for the land of the rising sun? After hitting a five-year high in December, Japanese share prices this month fell by close to 8 per cent over the course of just a few days after turmoil on the Tokyo stock exchange.

In 2005, the Nikkei 225 Index of shares in leading Japanese companies rose by 40 per cent, to just over 16,000. Then, early in the new year, fraud allegations about Livedoor, one of the country's best known internet companies, sparked panic selling in Tokyo and wiped 1,000 points off the index in less than a week.

It's a familiar story. Over the past 17 years, there have been a series of six-month bull runs on the Japanese stock market. Each has been followed by a much longer bear market. Since the Nikkei peaked at 39,000 in 1989, the market has collapsed - it was down to 7,700 by 2003 and remains at less than half its historic high.

However, the experts are queuing up to argue that this time will be different. Ben Yearsley, an analyst at independent financial adviser Hargreaves Lansdown, says: "Be patient - there have been too many instances in recent times of people losing their nerve and selling investments for the wrong reasons."

Yearsley believes the recovery story in Japan remains compelling. "The fundamentals of last year have not changed over the past few weeks and this month's dip could be a buying opportunity," he says. "I've still got 20 per cent of my pension fund in Japan."

Darius McDermott, managing director of Chelsea Financial Services, is also relaxed. "This fall has been a good thing because people had begun to get a little concerned that some shares were overvalued," he says.

There are grounds for optimism. Japan's equity markets collapsed during the Nineties after the bursting of financial and property bubbles devastated the economy. Despite attempts to restructure the economy, Japan has struggled for 15 years to break out of deflation and stagnation.

Last year, however, the reforms introduced by Prime Minister Junichiro Koizumi finally started to pay off. Positive data included stronger economic growth, rising exports, falling unemployment and a series of surveys suggesting significant increases in business confidence. Last year's recovery was primarily export-driven - the rising economic power of China was a particular boost for Japanese companies. In 2006, Jamie Jenkins, head of the Japan desk at Foreign & Colonial, believes domestic investors will help push Japanese share prices higher.

"An important precursor to strength in Japanese equities in 2006 will be further evidence that Japan has emerged from an environment of deflation," Jenkins says. "This would encourage a return of domestic investors into the share market."

Kenichi Ura, manager of M&G's Japan Smaller Companies Fund, adds. "The recovery is slowly rippling into the crucial domestic consumer sector and banks really do seem to be putting the period of deflation behind them."

Even so, a downturn in the global economy would hit exporters hard - any unexpected setbacks in the US or China would be particularly difficult.

Also, investors must decide whether last year's gains have left the stock market over-valued. David Shairp a global strategist at JP Morgan Asset Management, says last week's wobble was a welcome pause for breath. "From a technical perspective, the Japanese market has become extended," Shairp says. "Our sense is that this pull-back represents a needed period of consolidation that will be the prelude to a period of expansion."

Even if Shairp is right, investors may be in for turbulence. "Japan is sleeker, more efficient and more shareholder aware, but that does not mean all of Japan's ills are cured," warns Justine Fearns, of financial adviser Chase de Vere.

"While excitable fund managers talk of the Nikkei hitting 20,000 in two years' time, it could be a very choppy ride getting there."

Four funds with Eastern promise

Legg Mason Japan

"This is our favoured fund for Japanese exposure," says Darius McDermott, of Chelsea Financial Services. "But while it has been a very strong performer, investors should note that it can be very volatile - if the market moves by 3 per cent, it will move 6 per cent."

JP Morgan Japan

"We rate all Japanese funds as a nine or 10 out of 10 on the risk scale, but for those investors looking for a less volatile option than the Legg Mason fund, JP Morgan is our fund manager of choice," adds McDermott.

Schroder Tokyo

"Schroder Tokyo's performance has been a little disappointing during the past year," says Ben Yearsley, of the independent adviser Hargreaves Lansdown. "But even so, it has been a consistent performer over the longer term and is still worth backing."

Old Mutual Japanese Select

Another option, Yearsley suggests, would be Old Mutual's Japanese equities team, which is headed by Leslie Jones, one of the longest serving managers in the sector.