Japan’s Nikkei Stock Average, one of the country’s key benchmark indices, rose 2.3% last week, finishing May with a 3.5% gain. Since March 17, the index is up 22%. Still, the index remains down 6.3% year to date, compared to a 4.6% dip for the S&P 500.

That has some bargain hunters intrigued, as Japan remains the world’s second-largest economy, with exposure to the emerging markets of Asia. Viewed in the go-go days of the last bull market as a country with a slowing economy and an aging population, Japan is now seen by some as a market that’s been beaten down.

That’s the subject of debate. Monday, the Nikkei 225 fell 1.6%, leaving it 22% lower than its eight-year high, reached in July 2007.

In mid-May, S&P Equity Research’s Alec Young said the fundamental outlook for Japan is not clear, thanks to continued weak economic growth. Fact is, the Japanese market has had its troubles over the past 20 years, and volatility—exemplified by the ups and downs of recent days and weeks—has made it “a tough place to make money,” according to Morningstar.

The country struggled through a devastating bear market in the early 1990s and has never fully recovered. For a decade, GDP growth hovered around 1% annually, and it’s been around 2% since 2002—while, of course, emerging markets boomed.

The average Japan stock fund lost 9.1% in 2007 and 1.7% in 2006, trailing the MSCI EAFE Index by nine and 26 percentage points, respectively.

While PowerShares FTSE RAFI Japan ETF's (PJO) history is short, it is not a typical Japan fund—most are cap-weighted, while PJO uses fundamental factors such as sales, cash flow, book value and dividends to choose stocks.

The Nikkei is off more than 20% since the fund’s June 25, 2007, inception, but PJO’s NAV is down just 2.1% (through June 2). Likewise, PJO has beaten the MSCI EAFE (EFA) (Europe, Australia and Far East) index in 2008.

In moving from 37th to 21st on our PowerShares Momentum Tracker table over the last five weeks, PJO held the top ranking for an international fund.

The ETF holds a portfolio of about 330 stocks, a representative sampling of the biggest players in Japan. With an average market cap of $13.6 billion, more than three-quarters of the fund’s holdings were in stocks classified as giant or large cap by Morningstar. But the fund also brings a 23.6% stake in mid-cap stocks.

PJO is heavy on consumer discretionary stocks, which recently made up 22.9% of assets—a result of Japan’s massive consumer electronics industry—as well as the shares of industrials (19.2% of assets), both in much heavier concentrations than the S&P 500. Likewise, it’s relatively light on healthcare stocks (2.7%) and, especially, energy shares (just 2.1%). The latter two sectors recently made up about 25% of the S&P.

The emphasis on consumer discretionary stocks exemplifies the fact that Japan relies heavily on exports, with the U.S. as its biggest market.

Toyota (TM) shares are down 17% in the last year, despite record sales and profits for 2007. In May, the company forecasted a 30% decline for the current business year, thanks largely to the U.S. slowdown.

Export-oriented Japanese firms, according to a recent editorial in Japan Times, “find themselves caught in the swirl of the steep fall in the value of the U.S. dollar against the yen, rising raw material costs and the economic slowdown in the United States caused by the subprime mortgage crisis.”

Shares of Panasonic maker Matsushita Electric Industrial (MC), Sony (SNE) and Canon (CAJ) have held up well, however. Sony shares jumped 10% in mid-May, after the company released a strong forecast for 2008 and 2009. Matsushita, pushed by demand for digital cameras and home appliances, registered a strong FY 2007 and shares are up 13.9% YTD. Canon shares are up 21.1% in three months, despite weak earnings and forecasts.

The other issue with Japan, one that’s more worrisome when one looks past the stocks of Honda (HMC), Sony and Canon among PJO’s key holdings, is domestic consumption, which has slowed in recent years, thanks to stagnant wages.

Bank stocks, such as No. 2 holding Mitsubishi UFJ (MTU) (shares up 14.5% YTD) and No. 10 Mizuho Financial Group (MFG) (up 36.9% YTD, partly on a large share buyback plan), have rallied recently but face crimped earnings from stalling interest rates, according to HSBC Holdings.

Though rebounds have been predicted numerous times, Morningstar’s William Samuel Rocco sums up the situation thusly: “The consensus view on the macro situation in Japan has switched back and forth between the glass being half full and the glass being half empty a number of times during the past decade.” The result, he says, is extreme volatility.

In recent years, that’s also meant underperformance, though PJO’s recent rally is a positive sign. Time will tell if the glass-half-full sentiment can help the ETF to a run of outperformance.

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Don Dion

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