Japan’s stock market has been in a long, secular bear market for two decades. But that has been punctuated by fierce rallies. Martin Hutchinson says another spike could be on the cards next year as the Nikkei tests its 2003 low. He picks three Japanese stocks with a strong bounce potential in a market recovery.

This from Money Morning:

Japan has been an infuriating country for U.S. investors for almost 20 years now, since its benchmark Nikkei 225 index hit its trading high of 38,957 in late December 1989. The market then dropped steadily to a third of its peak value by the end of 1998, zoomed back up to 20,000 in March 2000, fell to a low of 7,600 in March 2003, and then recovered to 17,600 in June 2007.

Now, however, it has swooned to 8,695, infuriating global investors. And there’s two ways to look at it.

You can regard it as hopeless case, a market stuck in permanent recession.

Or you can look at the money investors made in 1998-2000 and 2003-2007 and say: “It’s down close to 8,000 again, lads. Time to pile in!”

On the whole, I’m inclined to the second view.

Burst Bubbles

Japan made a number of mistakes in the 1990s – most notably in allowing its public sector to grow so much that it delayed the recovery from the inevitable downturn brought on by the huge Japanese stock market and real state bubbles of 1985-1990.

However, the Japanese economy’s productivity hasn’t stopped growing: According to The Conference Board Total Economy Database, the world’s second-largest economy grew at an average annual rate of 2.0% from 1990 to 2007, outstripping the U.S. productivity growth rate of 1.8%, and the 1.6% rate of Germany, for instance. Thus, Japan’s economy retains considerable dynamism, and being almost two decades from its bubble excesses, has worked the bad debts and overvaluations out of its system.

One factor that trends in the opposite direction is the September ascent to power of new Japanese Prime Minister Taro Aso.

Back in 2003, before Aso came to power, then-Prime Minister Junichiro Koizumi had finally (it seemed) quelled the public spending barons in Japan’s Liberal Democratic Party and cut back infrastructure investment. Koizumi’s two successors were both similarly committed to spending restraint – highly necessary in a country whose debt had peaked at 180% of gross domestic product (GDP). However, Prime Minister Aso also is a believer in “stimulus,” and with so many bad examples internationally (and others – such as China’s – so new that we can’t yet pass judgment on them), it seems inevitable that he will relax Japan’s budget discipline. This may help the country’s slowing economy in the short run, but in the long run it threatens to return Japan to its stagnant state of the late 1990s.

Nevertheless, Aso’s first stimulus program – announced Oct. 31 – was a fairly modest $30 billion (about 27 trillion yen), or roughly 6.0% of GDP. What’s more, only $5.56 billion (about 5 trillion yen) of that outlay represents actual new spending, with the rest represented by tax rebates and service-charge reductions. So, while Japan’s deficit and debt will increase, the government’s share of the economy won’t increase much. This brings hope that Aso will remain sufficiently restrained in new public spending programs to allow the Japanese economy to start growing again.

The financial markets seem to think the outlook for renewed growth is quite good; the yen has been very strong in the last few months, reaching a level of Yen 92 = $1 that it had only touched in the middle 1990s (Yesterday, Yen 95.95 = $1 USD).

Of course, it doesn’t hurt that Japanese banks – restrained from rapid expansion in the 2003 to 2007 time frame because of their previous bad debt problems – had been lucky enough to avoid most of the U.S. subprime mortgage mess. This all bodes well for carefully chosen Japanese stocks.

Reaping Profits

With faster productivity growth than the United States, a reasonably valued stock market, and some degree of shelter from the storms afflicting the rest of the world, Japan is an essential home for a portion of your international investments. While Tokyo will most definitely be affected by a continued decline in the worldwide stock markets, if viewed solely on its own merits, the Japanese stock market seems more likely to rise than fall. You never know: We could be close to the beginning of a long, secular bull market – it has been a full generation since the last one. More likely, the market will just bounce a bit. Still, even bounces are worth buying.

In terms of which Japanese shares to buy, the major electronics and consumer goods exporters should be avoided – their earnings have been decimated in the past few months. One exception to this is in the auto sector: Honda Motor Co. Ltd. (ADR: HMC) has a better model range and is better aligned for a world marketplace plagued by expensive fuel and environmental pressures than any other manufacturer on the planet. But it too has been knocked back by the problems of auto manufacturers in general.

Honda’s American Depository Receipts (ADRs) are down about 36% from their 12-month highs. But at about 9.0 times estimated earnings to March, with a dividend yield of 3.6%, they seem a good value.

The profit problems of the major Japanese high-tech companies have caused the entire tech sector to suffer earnings reverses – except the domestically oriented cellphone company NTT DoCoMo Inc. (ADR: DCM). Naturally, DCM’s sales and earnings have been growing only slowly in Japan, because the wireless-communications market is saturated. But the company addressed this problem on Nov. 12 by shelling out $2.7 billion for 26% of the Indian cellphone company Tata Teleservices Ltd., entering into a technical cooperation agreement.

As of Sept. 30, India had 315.3 million cellphone subscribers, up 51% in the year and surpassing the overall U.S. population for the first time. With a forward Price/Earnings (P/E) ratio of 13 (based on earnings to March), and a dividend yield of 3.0%, DCM is also a bargain – given the technological improvements in the sector and its new growth potential in India.

Finally, a “fundamental” product – and one that’s primarily domestically oriented – is the chief business of Wacoal Holdings Corp. (ADR: WACLY), the world’s largest manufacturer of intimate apparel. Wacoal dominates the Japanese market, which accounts for 85% of its sales. Any economic recovery in Japan is likely to be domestically based, thanks to sluggish export growth and the strong yen. Hence, Wacoal is well positioned to benefit. The stock is trading at about 20 times forward earnings to March, and has a dividend yield of 2.2% – pricier than the other two, but worth a modest investment.

Source: If Japan Bounces Back in the New Year, Investors Will, Too