FEAR is rife in financial markets, even though things seem to be going pretty well. That is why two days of scandal and incompetence on the Tokyo stock exchange (TSE) made the world catch its breath.

Recession is virtually off the world map; inflation looks firmly under control and interest rates are moderate and relatively stable across most of the globe. Yet, far beyond the forever fretful few, investors, analysts and even consumers are looking over their shoulders lest disaster strike.

The three-year bear market and the shadow of 9/11 are keeping us on edge. Oil prices, gas shortages, trade imbalances, currency collapses, a Chinese implosion, defoliation of hedge funds, terrorism and war are all viewed as potential agents of doom. Risk, which was normally paired with reward, is becoming culturally synonymous with impending danger, to be avoided if at all possible.

Nowhere is this combination of nightmare vision versus benign reality starker than in perceptions of the Japanese economy and share prices. The shadow cast by the bursting of Japan’s asset bubble 15 years ago is inevitably much longer than the aftermath of the dot-com bubble, even though Japanese financial markets suffered badly from that too. False dawns have appeared more often than leap years, only to turn dark again as soon as some special export or state spending stimulus goes or after inept monetary or fiscal action.

The sudden regulatory onslaught against Livedoor, a company not even listed on the main Tokyo market, has come at a particularly nervous time for investors wondering whether to trust the Japanese market again. Shares were poised either to break out of the confines of the past 14 years or to sink back yet again.

The two main Japanese share indices tell different long-term stories. The Nikkei, which peaked just short of 40,000 at the very end of the 1980s, has ranged between successively lower peaks and troughs, partly because it has been weighed down by financial stocks. The TSE’s Topix index has also oscillated widely but has hit the same ceiling, at about 1,700, four times.

On January 5, the Topix index peaked at 1,685 and the Nikkei was at its projected next peak of about 16,000. Will they make it this time? This week’s blip has by no means decided the issue. Some dithering resistance would be expected, as investors, who have finally retrieved their losses, cash in for safety’s sake. The Livedoor affair is an added complication.

Ordinary Japanese savers and corporate funds, which powered the bubble, have long since quit the scene. Hedge funds have accounted for a high proportion of TSE turnover but as the Nikkei outpaced other world markets in the second half of last year, individual day-trading speculators operating online took over, focusing on tech stocks again. Hedge funds, having operated so profitably through previous share price cycles, are the most likely sellers now, though it was small speculators who sold in panic after Livedoor was suspended and rejected as collateral for buying on credit.

Japanese savers have yet to return in the old numbers. Many have switched from cash into gold as consumer prices stabilised and holding cash with no interest became pointless. Institutional investors are much more supportive and fund managers from the West, having returned to Japan, will not be put off now.

For them, the market cannot long ignore the tremendous improvement in the state of Japan’s economy and the finances of quoted companies. Japan’s gross domestic product grew 2.3 per cent in 2004, is thought to have grown by 2.5 per cent last year and is expected to do a little better this year.

Exports to China are strong but so is business investment, based on strong cashflow and the strongest balance sheets since the Japanese economic miracle ended in tears. Even consumer spending is expanding at about 2 per cent a year, as unemployment drops and real pay increases, giving a solid, if modest, domestic base for growth. On the stock market, the biggest success stories of last year were steelmakers and an energy-linked construction group. This reflects real profits and prospects, not a bubble. Even optimists expected a correction after the advance of the past 15 months.

Risks remain. Japanese shares still have a much higher rating than American ones, let alone UK companies, although buoyant profit reports in the spring will shrink the gap. Debilitating deflationary falls in the general price level are not yet definitively past. Banks have not quite started lending more to business than they are clawing back in repayments. The budget deficit is still running at more than 5 per cent of national income, which needs unwinding. At some point, perhaps by the middle of this year, the Bank of Japan will also have to start charging for money again or risk a new asset bubble. It can all still go horribly wrong. That’s risk for you.

graham.searjeant@thetimes.co.uk

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