Kevin Armstrong: Tokyo bull is a lumbering beast

Four months ago I wrote about the turmoil that was then occurring in the Japanese share market and compared the move of the past few years in Japan to the early stages of the great bull market in the United States that began in the early 1980s and only ended in 2000.

The particular comparison I focused on was the remarkable performance by smaller companies in the early stages of the US bull market over 20 years ago and the similar outperformance of smaller companies in Japan over the past three years.

I concluded that, although it was quite possible Japan had now finally seen the back of its 13-year-long bear market and economic slump its recovery, particularly in the share market, would not be a smooth, uninterrupted rise. Lengthy bull markets never are and they are frequently interspersed with bear markets or corrections that can last from one to two years.

Since then the Japanese turmoil has turned into something of a rout, particularly among those smaller companies. Since mid-January the previously soaring Tokyo Second Section of smaller companies has fallen more than 25 per cent and in just the past two months the broader Nikkei index has fallen almost 20 per cent. These moves have not been limited to Japan.

Over the past few months reversals have been seen in most markets of the world, with the largest corrections in those markets that had been previously rising the fastest.

The question all investors must now deal with is whether these reversals are the harbinger of something more serious or have they just been the so-called "healthy corrections"?

Just what a healthy correction is, I'm not sure; it clearly must be an oxymoron. It's hard to imagine just who finds a correction healthy, certainly not any investor who got in just before the so-called healthy correction began.

Nonetheless we've been hearing a lot about healthy corrections.

Over the past couple of months these so-called healthy corrections have seen the price of gold fall from US$735 to $560, down 25 per cent, and some of the emerging markets fell by half, and all these reversals have been remarkably synchronised. As the reversals have occurred so have various measures of volatility risen and risk appetite fallen.

Until recently investor sentiment enjoyed a remarkable recovery, from the outright fear that was apparent in 2002 and early 2003 in the wake of terrorist attacks, corporate corruption and the bursting of the massive technology-led mania, to something approaching complacent speculation.

From the low, three or four years ago, in many asset markets the economic fundamentals did eventually improve to the point that further gains in most markets and assets appeared almost obvious.

Accompanying this improving backdrop was a growing degree of speculation and confidence.

This speculation was most obvious in commodities and emerging markets where price charts accelerated higher.

At times such as this it is vital that any investor understands the timeframe over which he is investing because the frailty of human nature results in our time horizons expanding and contracting almost at the whim of market movements.

China's emergence as an economic powerhouse has been apparent for several years and its seemingly insatiable appetite for many of the world's hard commodities has also been widely reported. A while ago it was reasonable to justify the price appreciation of selected commodities on increased demand from China, but a lot more than simple supply and demand drives the price of any asset. As the story of China's demand became more and more well known, a whole new breed of commodity investors emerged and a somewhat self-fulfilling cycle of accelerating prices began.

As the prices of gold, copper, zinc and other metals soared higher the "truth" behind the long-term story of China's emergence apparently became increasingly obvious to a growing number of new initiates, and a speculative bubble of some degree was born.

Unfortunately this speculation had taken prices a long way away from whatever long-term fundamentals might have justified. This is where an investor's timeframe becomes so important.

The long-term argument about China is undoubtedly true, and it will almost certainly result in much higher prices for many commodity and investment markets over many years, but the path to wherever the ultimate high prices may be, in what some have described as a new "super cycle", will not be a smooth, ever-accelerating path higher. The same comments can be made regarding Japanese stocks.

A new long-term, potentially multi-decade bull market in Japan most likely started in 2003.

Eventually new all-time highs will be recorded in the Nikkei but, as I said earlier, long-term bull markets are always interspersed with corrections or cyclical bear markets that can last up to two years.

Frequently, these cyclical bear markets are not due to any material deterioration in the underlying fundamentals of the market; instead they are the result of the elastic that connects market prices with fundamentals from becoming too stretched.

At the end of such cyclical bear markets the complacent belief in the previously "obvious" long-term story of the latecoming new initiates is shattered along with their once good intention of holding for the long term.

As a result frustrations grow through cyclical bear markets and all investors are tested.

Despite the disturbing action of the Japanese share market, many emerging markets and selected commodity markets over the past couple of months, the very long-term "story" behind these markets remains valid.

However, this current test, or cyclical bear market, could well last longer and fall more than many, particularly latecomers, are prepared to tolerate.

* Kevin Armstrong is chief investment officer for the ANZ Bank and National Bank.