Despite an overall lacklustre performance for the market, given strong rallies in other leading stockmarkets, there was a noticeable shift in market leadership with smaller companies starting to underperform larger companies. This can probably be attributed to the sharp decline over the preceding months in large caps and the significantly higher than expected quarterly earnings announcements that produced several unexpected upward revisions. Of less surprise but as encouraging was the dramatic improvement in terms of free cashflow, a reflection of the significant restructuring over the last 18 months, which we continue to believe has been under appreciated by investors. With capex levels now running below depreciation this trend should continue. In addition, it may also explain why the corporate sector has been significantly less animated about the recent yen appreciation.

The conundrum that lies ahead is this: valuations on large companies have fallen so sharply that they no longer look expensive compared to more durable, less cyclical companies. The issues going forward are clearly the extent of any further yen appreciation but more importantly whether the recent weak economic data, especially in the US, is a forewarning of slower top line sales in the coming months. Will the developing economies compensate for the anaemic growth in the developed economies?

Our sense is that there are minimal prospects for any sudden reacceleration in US growth rates. We remain concerned that recent Japanese corporate results exaggerate the underlying margin levels as inventory restocking has clearly produced an unusual and probably unsustainable positive impact on selling prices which will correct as the very tight demand/supply conditions ease from here. We do expect that any near term investor interest may centre upon the more cyclical larger cap companies but given our outlook we are not prepared to sacrifice our more durable earnings growth situations. Furthermore with a political impasse following the Upper House Election, expectations for any developments in government and/or monetary policy look remote and this has further depressed more domestic sectors, especially financials and real estate. Whilst we do not own banks, we concede valuations, both within the market and globally, do not appear expensive. If and when macro investing finally subsides, Japan should prove a lucrative market given the abundance of very inexpensive stocks although the index may struggle given that the only marginal buyer, the foreigner, is reluctant to participate against the clearly slowing global economic indicators.

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