Kevin Armstrong: Bull in the sushi shop - but for how long?

With the turmoil in the Japanese equity market, questions are being asked as to the viability of, and prospects for, the current bull market.

Given the many false starts that have been seen in Japan over the last 15 years, these concerns are understandable. Clearly, a new bull market is overdue after such a protracted period of dismal performance, but just because something is overdue it doesn't mean it is imminent. Nonetheless this current move and the improving fundamentals raise one's confidence in this being the start of something far more enduring than any of the recoveries during the 90s.

The move in the Nikkei has been impressive; it rose 45 per cent last year and is now more than 100 per cent above the levels seen in mid-2003.

These moves are welcome, and have clearly rewarded investors who were bold enough to attempt to catch what many thought was the falling knife of the Nikkei. But compared to the magnitude of the enormous bear market that preceded this rally they become less significant.

The Nikkei is still down more than 60 per cent from its high achieved on the last trading day of 1989. This doesn't mean that a new bull market can't be declared until after a new high is recorded, but that manic 1989 peak still casts a shadow over the history of the Japanese market.

Whilst this rally has been healthy in the Nikkei, it has been dazzling in the more speculative parts of the Japanese market. The Tokyo Second Section, an index of smaller, lower-quality companies, has literally soared over the last three years and has now risen to an all-time high (a level equivalent to Nikkei 39,000).

This move is concerning on two fronts: firstly the Second Section now sports a P/E of 130 and secondly the nature of the move highlights the magnitude of the speculation that has been present in this Japanese bull market. Rampant speculation with near-vertical rises should raise cautionary flags for investors. But it does not necessarily mean that a new, longer-term bull market is coming to an end; far from it. A similar picture was seen at the start of the last great secular bull market in US equities.

Back in the early 1980s US shares had been marking time in a frustrating, broad trading range for about 15 years. Then, in March 1980, in the midst of a recession, US equity markets began to rally and the biggest moves were seen in the smaller, more speculative companies. The Russell 2000, a broad index of the companies below the largest 1000, soared from a low of 45 to a high of 127 by mid-1983.

High-quality companies also rallied, just not as spectacularly, with the S&P 500 rising 70 per cent. Smaller companies outperformed larger companies by over 60 per cent over this 27-month bull move.

This spectacular blow-off in smaller companies did not mark the end of the bull market; in fact it was only the beginning. No enduring bull market ever went up in a straight line.

Following that first three years of bull market action in the US, there was a cyclical bear market, lasting just over a year. Understandably, the biggest correction was seen in the previously dominant smaller issues; the Russell 2000 index fell by more than a quarter while the lagging S&P only suffered half that decline. The S&P, which had underperformed dramatically in the early stages of the bull market, took over the leadership role in the first decline and maintained that dominance for much of the rest of the lengthy bull market, with smaller companies only moving back to the fore in the last five years.

In a remarkable echo of the start of the last secular bull move in the US, Japan is currently exhibiting many of the same characteristics, with the smaller companies in the Second Section outperforming the Nikkei by over 60 per cent.

Neither the current volatility nor the speculation in smaller companies should be seen as the end of Japan's bull market. But it is reasonable to question whether smaller companies will continue to dominate and also whether, after three years of advance, some consolidation in the broader Nikkei index is not overdue. If the parallels with the US 20 years ago were to continue it is possible that any period of consolidation could last a year or more, even while the longer-term bull market remains intact.

The reasons for owning Japan for the long term are still very much intact, but, with the region appearing to be everyone's favourite, it is possible that the first-up leg is now over. Further purchases of Japan, from a long-term perspective, are warranted, but it will likely pay to adopt a more opportunistic approach, with the aim of buying on weakness, during any cyclical correction.

* Kevin Armstrong is chief investment officer at ANZ National Bank.