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Sultry Summer for Japanese Stocks

Now, investors wonder if the revival can continue.

Editor's Note: To view Gregg's video take on Japanese stocks, please click here.

Kids aren't the only ones dreading the end of summer. Investors in Japanese stock funds would also love to extend what has been a surprisingly strong season.

The average Japan-based mutual fund is up nearly 9% over the past month, according to Morningstar, while the run-of-the-mill U.S. fund spent its summer vacation around the flatline.

The rally in Japanese shares is most clearly seen in the strong performance of the

iShares MSCI Japan Index

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exchange-traded fund, the 10th-largest U.S. ETF with more than $6.3 billion in assets. EWJ is the sixth-largest exchange-traded fund in terms of daily volume, which has risen more than 10% since late July.

Japan's rally comes as everyone spent the summer wringing their hands about China. The financial press packed its pages with stories comparing China's economic ascendance to that of Japan in the 1980s, partly in response to


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failed attempt to purchase U.S. oil giant Unocal, which was later snapped up by


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Likewise, the stunningly successful IPO for Chinese Internet search company

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drew parallels to the tech-driven bull market of the 1990s in the U.S.

But aside from Baidu's rise, Chinese stocks have spent the past few weeks meandering aimlessly. Meanwhile, over in Japan, a strengthening dollar and a radically altered political landscape are giving investors optimism that Japan Inc. may be back in business.

Going Postal

As odd as it may sound to American ears, the catalyst behind the Japanese rally was a failed vote to reform the post office.

Unlike the U.S. Postal Service, which mainly stuffs mailboxes, the Japan Post is a sprawling financial giant that includes the world's biggest deposit-taking institution, holding some $3 trillion in assets. Japan Post has nearly 25,000 offices and 260,000 employees.

Unfortunately, it's also been operating inefficiently for decades, financing pork-barrel projects in rural areas on a scale that would make even congressmen blush. That's why Prime Minister Junichiro Koizumi staked his political future on an aggressive reform and growth agenda to split the Japan Post into four units and create of the world's largest private bank.

On Aug. 8, Koizumi's proposals were defeated in Japan's upper House of Councillors. Not taking defeat in stride, Koizumi took his quest to a new level. He called for a general election on Sept. 11 and banned members of his own Liberal Democratic Party who voted against privatization from running on the LDP ticket.

"By calling an election and expelling the rebels, he is betting that the Japanese public have a larger appetite for reform and that a more unified LDP can continue to reinvigorate the Japanese economy," says Campbell Gunn, portfolio manager for the

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T. Rowe Price Japan fund.

So far, that wager has paid off. International funds have been flowing into Japanese stocks in advance of the September vote. More important, domestic Japanese investors are piling in as well -- a departure from the hit-and-run foreign money that has killed off similar rallies in the past.

"He kicked over the card table," Mark Headley, portfolio manager for the $181 million

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Matthews Japan fund, says of Koizumi's bold move.

Headley says Japanese financial stocks like



Sumitomo Trust & Banking

will be the big winners if and when the postal system is reformed. And unlike in the U.S., where the threat of higher interest rates is causing investors to avoid banks, the Japanese have no such worry, says Headley.

"Interest rates moving up from zero would be the most positive sign, but they won't be too quick to raise rates," says Headley. "They are more paranoid about deflation, and inflation is nowhere to be found."

The Yen Goes Zen

Even if Koizimi's refocused attack is shot down in the September election, Japanese fund managers are confident that the market momentum is likely to continue now that global investors are once again paying attention to Japan's domestic economy -- and seeing good things.

Although there was a mini-Internet bubble in 2000, the Japanese market has moved up and down with exports and global consumer demand over the last 15 years. What has been lacking is a sustainable recovery in the domestic economy. But T. Rowe's Gunn says that's changed, as Japan's famously bad banking system has evolved and many long held economic bad habits have been broken.

"Banks have finished bad debt writeoffs and are now repaying the government's capital injections, consumers are spending again, corporations are awash with cash and are rehiring full-time workers and the real estate market has bottomed," says Gunn.

All in all there is a growing consensus the domestic economy is improving says Headley who points out that real estate prices are up for the first time in a decade while unemployment has move lower to 4.2% in June from 4.4% in May.

Despite the acceleration in Japan's domestic economy, the island nation's financial future will always remain dependent in its ability to export. That's why the renewed focus on Japanese equities has caused some worries over the yen, which has also spent the summer in rally mode, albeit a moderate one.

Nevertheless, fund managers say the Japanese are far more sanguine about the state of the yen than in years past, mostly due to the dollar's recovery from its free fall.

"The crashing dollar chorus was worrying to Japan Inc.," says Headley. "But this time the yen has rallied alongside the market."

Headley says the yen has to drop below 100 from its current perch of 110 per dollar to hurt. Furthermore, he says Japanese companies have been far more adept at hedging their currency risk.

They are also less beholden to currency market volatility because much of their manufacturing production now comes from plants outside the country. Auto manufacturers like


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, for example, continue to crank out cars to meet U.S. demand, without the union and pension headaches faced by

General Motors

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"The Japanese auto companies avoided the incentive war that began in 2000, choosing to compete based on product and not price discounts," says Gunn. "This strategy remains unchanged today, but reality is that they had to start participating once the incentive gap reached about $2,000 in mid-2003."

That said, profits continue to rise for Japanese automakers, as the cost of incentives have been largely absorbed through a combination of cost rationalizations, market-share gains and an improvement in product mix.