Slouching Toward Recovery; The sick men of the industrial world enjoy surprise bull markets. But only one has legs.(economic recovery, Germany, Japan)(Cover Story)

Byline: Karen Lowry Miller

Germany and Japan have shared many things in recent years. The labels "sluggish" and "inflexible" come to mind. So do phrases like "weak business confidence" and "delayed corporate restructuring." For a few months last year, they were often mentioned in the same sentence as one of the most rare and debilitating economic diseases: "deflation." Japan had it; Germany looked likely to get it. The question is, if these nations have been so sick, why are their stock markets booming?

One reason is that they had been beaten down so far. In a world awash in cheap money seeking high returns, some was bound to wash up in Germany and Japan. The German DAX index has soared some 85 percent from its low in March 2003, but European shares are still cheaper than American ones. The Nikkei index is up 30 percent in the same period, and it, too, is cheap compared with New York markets.

But here the paths diverge. Although Germany still has some upside, its economic recovery has no traction, and the markets are expected to top out pretty soon. The Japanese economy, on the other hand, is taking on a healthier glow. Despite three false recoveries in a decade, economists believe it might be real this time. Japan--the original "sick man" of the rich world--is, of all places, now the hot place to be.

Industrial production and domestic demand are both stronger than in the Eurozone, notes Goldman Sachs chief economist Jim O'Neill. Confidence is up, prices are falling at a much slower rate and pockets of the economy show the first shoots of inflation. "We are watching Japan very closely," says David Bowers, global equity strategist for Merrill Lynch in London. "Europe is just a bystander."

Positive economic news has tumbled out of Tokyo in recent weeks, from machinery orders to retail sales. Michael Hughes, chief investment strategist of Baring Asset Management in London, cites further reasons for optimism. The Japanese population in the key spending age of 35 to 55 is finally growing again. Corporations have restructured their balance sheets and now generate cash worth 10 percent of GDP. Hughes's Boston headquarters even distributed a press release last week announcing its optimism: "We've all waited about 13 years for Japan, so when it does happen, people get fairly excited about it."

With data ...