A Rising Sun, Finally

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Japan's long-awaited revival is getting under way. This not another false start. Bad deflation is ebbing, business is reviving and the stocks are very cheap.

Japanese bank shares rallied 5% in July even while Japanese bonds were collapsing, despite the fact that the banks are massive holders of their government's securities. The reason was that investors worldwide realized that Japan's horrendous economic travails might finally be coming to an end. They are right. After 15 years of one of history's worst bear markets, Japan has reached a bottom.

True, we have seen several false starts in the long nightmare of the Nikkei decline, particularly in 1998-99. So why is it different this time? Why is this, as they say on Wall Street, an inflection point?

The answer: We are seeing a beneficial combination of historically cheap valuations (which investors at last want to exploit), the start of an industrial upturn and the easing of the ruinous deflation that has made buying something today a foolish exercise when it will be cheaper tomorrow.

The clearest evidence that a turnaround is actually here is the extraordinary collapse in the Japanese bond market. From a high in mid-June to mid-August, the price of the 30-year government bond has fallen 15%, giving up an astounding 14 years of coupon payments. After all, who wants to own a 1.1% coupon for 30 long years if inflation is about to resume?

Japan's economic outlook has improved significantly. The Bank of Japan's recently released Tankan survey of business prospects, which covers 10,000 Japanese companies, large and small, shows a meaningful increase in capital spending plans by large corporations. Businesses are not going to spend if executives think they can't turn a decent profit.

While the recovery is uneven to date, the crucial auto and electronics sectors are showing encouraging results. Prices of semiconductors, for instance, are climbing. And a revival in the U.S. economy will find in Japan a willing provider of high-end goods.

The expected end of Japan's crippling deflation owes a lot to the situation in China, which has ruthlessly imposed downward price pressure globally, with the biggest impact on export-dependent Japan. China's rulers, whose artificially cheap currency magnifies their advantage in low-cost labor, are now realizing that they can't keep this beggar-thy-neighbor game going.

They are under political pressure from economically important Hong Kong to end the deflation that has hurt the city as much as it has Japan. On the sixth anniversary of Hong Kong's unification with the mainland, a half-million people protested the policies that have produced the tanking of the city's property prices. Even though China isn't exactly a democracy, the rulership has to pay attention, as Soviet leaders learned.

The end of deflation is migrating from China to Japan and is a big factor in Japan's stock market recovery. The Nikkei has surged 30% since late April, yet has much further to go. It's not too late to participate in this rebound. Many of the country's stocks remain marvelous bargains.

Even after the upward move the Japanese market is selling at its lowest valuation in 14 years. Sanford Bernstein's analysis shows that Japan's equities are trading at 7.1 times cash flow (here, in the sense of net income plus depreciation). That is in contrast to the U.S. multiple of 12.2.

How do you best take advantage of this opportunity? I believe investors should keep things as simple as possible. The easiest and most cost-efficient way to go long Japan is to buy an I-share, the MSCI Japan Index Fund (8, EWJ), which tracks the entire Japanese equity market as measured by the Morgan Stanley Capital International, on a capitalization-weighted basis. The I-share's top ten holdings account for 25% of the fund; the two largest industry sectors are, not surprisingly, electronic hardware and automobiles.

This exchange-traded fund carries an expense ratio of 84 cents for each $100 of assets. This is half what you would pay for the average mutual fund specializing in Japan, according to Morningstar. Since we may find a brief market pullback or two as Japan's market improves, the best strategy is to scale into these I-shares. An effective approach to building a position here would be to dollar-cost average. This way, you invest the same dollar amount every quarter for several quarters, ensuring that you buy more shares when prices are low and fewer shares when prices are high.

Many professional investors are underweighted in Japan and will be net buyers until they reach their benchmark weightings. Start buying now. Once-in-a-lifetime opportunities come only once in a lifetime.

Lisa W. Hess is a New York money manager. Visit her homepage at www.forbes.com/hess.