Foreign institutions bought a net 3.4 trillion yen ($28 billion) worth of Japanese equities between February and May, more than half of it in March.
The massive inflow of money made the Tokyo Stock Exchange the world's best-performing major market in the first quarter, according to Sho Ikeda, general manager for investment research at Nikko Asset Management Co.
In retrospect, Tokyo stocks appear to have reflected Japan's economy. On June 11, the Japan Economic Planning Agency announced that the first quarter saw growth of 1.9%, the country's first positive GDP figure in five quarters -- albeit fueled mainly by massive public-sector spending. Japanese equities took a sharp upward turn, jumping almost 3%.
The equity buying doesn't mean foreign investors are bullish on Japan, however. Rather, it reflects policy moves by Japan's central bank, combined with fears about the sky-high level of U.S. stocks. "There was still a lot of doubt about financial reconstruction here in March," Mr. Ikeda said. "But when the Bank of Japan guided short-term interest rates to effectively zero, international hedge funds jumped heavily into the Tokyo market, and were quickly followed by U.S. and European pension funds that were very underweighted in Japanese equities."
Most foreign institutions still hold negative outlooks on Japanese stocks, but after doubling the value of their U.S. portfolios over the past two or three years, they are "more willing to accept the risk of further decline on the Japanese market than the risk of being out of it when and if a strong recovery gathers steam," Mr. Ikeda said.
The Tokyo market could prove a good place to be. The local economy appears to be stabilizing, and one very positive sign is that individual investors here moved back into domestic stocks when they saw the foreigners buying, said Eric Michel, president and representative director at State Street Global Advisors (Japan) Co.
"Some strategists see a technical upside for Japanese stocks, and Japan is certainly recovering on a short-term basis," he said. "The market here is still attractive on a price-to-book value basis. Sentiment isn't strong, but with the relatively small volumes being traded, any pickup might have a big impact on the market. And if the upside became solid, there could be a dramatic shift in portfolio allocations."
While the initial heavy buying was index-linked, by April the pattern had shifted to stock picking, particularly of Japanese blue chips such as Toyota Motor Corp. and Sony Corp., Mr. Ikeda said. "Foreign buyers are still going after high-tech issues here and companies that are global leaders in their industrial sectors."
The pile-on by individual investors and the rapid move to issue buying from index buying are encouraging signs, said Andrew Callender, chief investment officer at the investment division of INVESCO Asset Management (Japan) Ltd. "The shift from index to stock picking was faster than in any other rally on the Tokyo market in recent years, and reflects the fact that leading Japanese firms now have much stronger fundamentals."
Mr. Callender also likes the attraction of foreign pension funds and local individuals to over-the-counter issues, calling it important and positive for the overall market. "Despite a recent (late May) correction, OTC stocks have now covered all their underperformance of the last three years," he noted.
As the momentum shifted to stock picking, the Tokyo rally became strongly led by the high-tech sector, Mr. Callender agreed. "In fact, you could almost call it Nasdaq-led. There is a lot of investor interest in domestic affiliates of foreign Internet companies, like Yahoo! Japan, which tend to move in parallel with their parent firms." Both Mr. Callender and Mr. Ikeda expect growth and small-cap issues to remain attractive to foreign investors over the medium term. "These companies are newer and less rigid," Mr. Callender said. "They have more flexible management, and very importantly, they are not weighed down by large cross-shareholdings that have become such a burden to older, more established Japanese companies. I think we will see active Japanese portfolio managers putting a higher percentage of assets into domestic small-caps."
All market signs appear to favor companies with good fundamentals, particularly those that have shown themselves serious about restructuring, said Hajime Takata, chief strategist at the investment strategy department of IBJ Securities Co., an affiliate of Industrial Bank of Japan.
"The market is definitely sensitive to the health of the financial system right now," he said, echoing Mr. Ikeda's opinion that the central bank's money market moves were a key factor behind the rally in stocks.
He also expressed optimism that Bank of Japan policy will continue to lend support to equities, noting the central bank has shifted to quantitative targets for interest rates and has increased the base money supply. These moves, combined with greater disclosure of central bank policy should make investors both in Japan and overseas more willing to put money into Japanese stocks, he said.
Certainly, problems remain for the Tokyo market.
"Japanese companies have only just begun to unwind their huge cross-shareholdings," State Street's Mr. Michel said, "and Japanese pension funds remain overweighted in domestic equities. We will continue to advocate more global exposure for our Japanese clients."
These are factors bound to generate steady selling pressure on the Tokyo Stock Exchange for some time to come. And foreign institutions consistently display a strong intolerance to any delays in restructuring by Japanese corporations, said INVESCO's Mr. Callender, citing a parallel to the U.S. market between 1991 and '93.
"We will likely see pendulum swings between optimism and pessimism for quite a while," he added.