More than a hint of Eastern promise left in New Japan

Other than the deflating of the tech stock bubble, the year 2000 has so far been a quiet one for investors. Most of the main markets have failed to advance, and some are well down from their levels at January 1. With hindsight, the run-up in stock markets in the last quarter of last year, which seemed surprising then, now looks like an anomaly. It is probably best explained by fears about the possible impact of the Millennium bug, which led to a notable loosening of the monetary policy reins by the authorities in the States and elsewhere.

Other than the deflating of the tech stock bubble, the year 2000 has so far been a quiet one for investors. Most of the main markets have failed to advance, and some are well down from their levels at January 1. With hindsight, the run-up in stock markets in the last quarter of last year, which seemed surprising then, now looks like an anomaly. It is probably best explained by fears about the possible impact of the Millennium bug, which led to a notable loosening of the monetary policy reins by the authorities in the States and elsewhere.

Nobody who has been following the passage of the markets over the past couple of years can fail to have noticed that the correlations between major markets appears to be increasing. The key to predicting movements lies increasingly in analysing global money flows and relative interest rates. Another way of saying much the same thing is to point out there is still a big chunk of mobile money that shifts from one market to another in response to these differentials.

Not long ago this game was largely driven by the hedge funds, but now it has become institutionalised. George Soros has gone on to play a different game, but the big banks and investment institutions are all, in varying degrees, playing a variation on what his funds once did, though not with the same degree of leverage.

And the attempts by the Federal Reserve to slow the American economy with a round of moderate interest rate increases appear to be working. The last year of the US presidential term is rarely bad for the stock markets, and it looks increasingly likely any significant setback will be postponed until next year at the earliest.

The UK market, compared to its peers, still looks relatively unattractive. The yield curve remains inverted, rarely a good sign, though there are extenuating circumstances because long-term gilt yields are depressed by technical factors. The good news is that the round of interest rate increases over here may be close to peaking, which implies some recovery next year. But the UK market has performed poorly relative to the world index for the past two years. The main indices have effectively gone nowhere since mid-1998.

Internationally, the place to have been invested for the past two years has been Europe, which still looks relatively attractive, but the greatest enigma remains Japan. Last year was spectacular for the Japanese market, which sprang to life after years in the doldrums to record some sparkling gains. Anyone who decided to play the internet and technology theme at the start of last year would have done almost as well by buying the Japanese equivalent of Nasdaq as by buying the American original.

The Jasdaq index, as it is known, outperformed the main market indices by a factor of four before the hangover set in earlier this year (note from the chart how closely the behaviour of Jasdaq has mirrored that of the Nasdaq index, which underlines again how important common global factors have become in driving market movements).

Japan also remains the last great outpost of the active fund management profession. The number of funds that beat the index in Japan is significantly higher than in the US or the UK. Most of the specialist Japanese funds run by the better UK houses have comfortably beaten their relevant index over the past two years (and some, like those at Baillie Gifford and Martin Currie in Edinburgh) have done so for much longer periods. I am particularly impressed by the track record of George Veitch, Baillie Gifford's Japan expert, whose funds have not only consistently beaten the index for six years running, but done so with below-average volatility.

One of the problems with investing in Japan is picking the right index against which to benchmark your performance. The Nikkei 225 index remains the best known market index, and the one most frequently quoted in the media, but it is about as unrepresentative of the Japanese economy as the Dow Jones 30 is of the American economy. The Nikkei index was revamped a few weeks ago, but it is still not as representative as it could be.

Topix is a much better index to follow, since it more faithfully reflects the emerging force of the New Economy in Japan. That is one reason why the apparent collapse in Japanese share prices since the spring, which has seen the Nikkei fall from a peak of nearly 21000 to a low of 16000 in just two months, is not as bad as it might appear. The decline in Topix has been much less marked.

If you look at the most successful Japanese funds, it is striking how similar their strategies have been. Essentially, they have been buying shares in so-called New Japan and going underweight in banks and the industrial dinosaurs that dominate many traditional industries in Japan. It has been a highly effective strategy and one Mr Veitch and others expect to continue paying dividends.

Having made the case for having some exposure to Japan on a medium- to long-term view, the strategic arguments for investing there remain strong. The markets have been unsettled recently by uncertainty over the outcome of the general election and, more importantly, the sustainability of the incipient economic recovery.

The general election has been and gone, having produced what seems like a no-change outcome, with the ruling coalition retaining power, and the LDP party losing its majority of seats in the chamber. The short-term economic prospects are obscured by doubts about the reliability of the official statistics and concerns about the intentions of Japan's monetary authorities (who have made such a pig's ear of handling the crisis of the past 10 years and may yet undo the better things they have done in the recent past).

Anyone who invests in Japan needs to remember the markets have historically been more volatile than other leading markets, so big swings up and down are part of the price you pay. But the markets look attractive and the signs of emerging entrepreneurial talent in Japan's new economy companies are encouraging. To justify buying shares there, one has to believe the changes in the country's political and industrial structure will continue. It is no sure thing, but few of the best decisions in investment are.

davisbiz@aol.com