Up until yesterday, Bob Doll was on a roll. In his beginning-of-year forecast, Mr. Doll, in charge of equities for BlackRock, had projected greater volatility, increased credit spreads, a decent year overall, and better-than-average performance from the Japanese market. At the end of a tumultuous week, most of those expectations appeared intact, if not downright brilliant. (We’re still hoping for the decent year.)

Yesterday, though, the Japanese markets got clobbered. The Nikkei index was off 3.3%, and the broader Topix index was down 3.4%. These losses were on top of last week’s 2% drop. The market suffered its worst falloff since last June and basically wiped out the last years gains in one session. As of Friday, the Japanese market, though off for the week, was still ahead 1.3% for the year to date, compared with a 1.1% drop for the S &P 500. A leading exchangetraded fund, specializing in Japanese securities, iShares Japan, had been doing even better — it was up 3.4% for the first two months of the year.

Mr. Doll is unfazed. “Mostly, the Japanese market just caught up with the rest of the world” he says, noting that last week Japan’s indices were down less than the Dow Jones and most European markets.

In part, yesterday’s tumble reflected a strengthening yen, a concern to Japan’s exporters. The yen rose 1.2% against the dollar, and also rose compared to the euro. The falloff was also the result of lowered expectations for the American economy. A large share of the output of Toyota, Sony, Canon, and Japan’s other major exporters finds its way to America. Any ratcheting down of expected demand takes a toll on the earnings estimates of those companies.

One explanation for the rise in the yen was that those involved in the carry trade were unwinding their bets. The fabled carry trade, in which investors borrow cheaply in Japan to buy higher-yielding assets elsewhere, was much in the news last week as market participants looked for explanations for the widespread dumping of shares. The carry trade is another instance of the markets trying to take advantage of discontinuities, in this case the extremely low level of Japanese interest rates.

The only risk to this process would be a strengthening yen, which might wipe out the interest rate differentials. As investors have been reducing their positions, they have been buying yen, thus driving prices higher.

Still, the Topix slide suggests that investors are also downgrading the outlook for a recovery in Japan, since that broader index incorporates many domestic companies. Nearly all the sectors of the market suffered reverses, including financials and steelmakers. According to Bloomberg, one of the few bright spots was the pharmaceutical sector. Maybe with the markets crashing people will resort to popping pills to dull the pain.

The drop is a setback (or an opportunity) for many investors who had begun to see signs of life in Japan’s domestic economy. Mr. Doll does not view the slide as evidence of poorer prospects in Japan. On the contrary, he thinks the recent move by the Bank of Japan to raise rates supports his view that a rebound is under way. He acknowledges, though, that the picture is far from clear.

“It’s more of the same,” says Mr. Doll. “The signals about what I call internal Japan are very mixed. But it looks better than it did a year ago. We’re still expecting slow, steady progress.”

The case for Japan stems from the expectation that corporate profit growth in the country would exceed that of most of the other developed countries, and that valuations are relatively attractive. Japan has been on the verge of a recovery for so long that many investors have lost patience and moved on. This time, some say, it could be different.

Longtime Japan watchers like Mr. Doll are impressed with the cultural change in Japan. They see serious restructuring efforts beginning to bear fruit, as profit margins and returns begin to expand. Not only are the bulls on Japan positive on the outlook for the large trading companies like Canon and Toyota, they are also buying the domestic companies that would benefit from a more broad-based Japanese economic recovery.

Signs of that recovery are widespread, and include employment data, anecdotal reports of record bonus payments to workers, and, maybe most important, some signs of inflation creeping up. Whereas most countries, and especially America, regard inflation as the monster in the closet, Japan watchers regard some return to normal price escalation as essential for a robust consumer cycle in Japan.

The argument goes that the Japanese have been so traumatized by the deflation of real estate prices and the 80% collapse of the Nikkei from its high that it would take some evidence of reflation to prompt any drop in the savings rate. Currently, real estate prices have begun to inch higher, hinting at a more broadbased pickup.

Bottom line? “I am still comfortable that Japan will outperform this year,” says Mr. Doll. “It would take a bigger move in the yen to really damage their export trade.”

However, even the unflappable Mr. Doll can’t resist a closing shot: “Keep the seat belts fastened,” he said. Indeed.

peek10021@aol.com