(FORTUNE Magazine) – Dressed in a swallow-tailed coat, surrounded by members of his new cabinet posing for their traditional group photo, Japanese Prime Minister Junichiro Koizumi was riding high last month. Economic indicators had kindled hopes that Japan's economy had turned the corner. Foreign investors were piling into Japanese stocks, lifting the Nikkei average 44% from an April low. Two days earlier Koizumi had beaten three anti-reform rivals to clinch reelection as president of his Liberal Democratic Party. And now he had bucked the old guard again by reappointing his reform-minded Economics Minister, Heizo Takenaka.

But as flashbulbs popped at Koizumi's official residence, the markets were turning. Currency traders, reacting to statements by finance ministers meeting in Dubai, began to dump dollars for yen, bidding the value of the Japanese currency up to its highest level in three years. By day's end, fears that a stronger yen would undercut Japanese exporters knocked the Nikkei back 4%, the year's biggest one-day loss.

It was a rude reminder that the world's second-largest economy isn't out of the woods. Foreign investors lost hundreds of billions of dollars betting on a Japanese comeback in the sucker rallies of 1993, 1995, and 1999. Now they're plunging in again. In the past three months, overseas investors--including some of the world's biggest mutual funds and institutional players--have become net buyers of Japanese equities to the tune of more than $40 billion. In the week before Koizumi's reelection, Tokyo seemed to have more bulls than Pamplona. The yen's rise in the wake of the Dubai meeting has spooked the herd. But there are few signs of full retreat. Right or wrong, a growing number of foreign investors have concluded that after 13 years in an economic coma, Japan is finally leaping to its feet.

Can the bulls be right? Don't count on it. This stock market rally may yet have room to run. But the odds are that Japan is experiencing a cyclical recovery, in which the economy grinds forward at a slightly faster pace that falls well short of the vigorous, long-term acceleration that might have come from genuine structural change. "Tokyo stocks rise for six months, and suddenly Japan's economy is back," scoffs ING Securities Japan economist Richard Jerram. "To use the technical economic term, it's a load of crap."

The case for optimism gathered momentum in late spring as Japan's macroeconomic outlook brightened. In June the unemployment rate slipped back to 5.3%, from a record high of 5.5%. Real wages rose for the first time in two years. Even Japan's beleaguered banks seemed to be making headway, announcing that in the fiscal year ended in March, total nonperforming loans shrank 17%, to $398 billion--the first reduction of bad loans since 1997.

The real catalyst came Aug. 12, when the government reported that in the second quarter Japan's GDP grew at an annual rate of 2.1%--triple the consensus forecast--as manufacturers increased spending on factories and equipment to fill rising overseas orders. And the story just got better. A month later the government upped its second-quarter estimate to 3%--more than the comparable U.S. figure. By mid-September many economists had raised their Japan GDP forecasts for the year ending in March 2004 to above 2%. Analysts at nearly every major brokerage were beating the drum.

"The current rally is distinctly different" from failed Japan rallies of the 1990s, wrote Goldman Sachs strategist Kathy Matsui in a September note to clients. "Time to buy more Japan," exhorted Morgan Stanley analyst Naoki Kamiyama after members of his firm's global asset allocation committee increased Japan's weighting to 11%, up two percentage points, in their influential model equity portfolio. At Merrill Lynch, chief Japan analyst Jesper Koll declared that Japan had reached a key "inflection point" and predicted that authorities would vanquish deflation within the year.

A favorite theme of Japan bulls is that this year's recovery has staying power because it has been driven by corporate restructuring--unlike past recoveries, which were stoked by government spending. To hear optimists tell it, big companies have made great strides in shrinking payrolls, paring debt, and scrapping old equipment. The result? Profitability at large-cap firms listed on the Tokyo Stock Exchange is "higher today than at any point in the 1990s," according to analysts at Goldman Sachs, who estimate that P/E ratios for nonfinancial firms included in Japan's benchmark TOPIX index are now comparable to those of firms on the S&P 500. Stronger earnings have spurred growth and shored up stock prices, allowing companies to reinvest in new facilities. In the second quarter, capital spending soared 4.7%, accounting for nearly four-fifths of total growth, as firms like Pentax, Sharp, and Canon ramped up domestic capacity in anticipation of increased overseas sales. And in recent months a flurry of Japanese companies--including Sony, Toyota, Honda Motor, and Hitachi--have announced plans to use their extra cash to finance multimillion-dollar share buybacks. Some, like Pioneer, are even raising dividends.

Look closer, though, and the bull story is less compelling. It's worth remembering that the rally's starting point is April 28, when the Nikkei slumped to a 20-year low of 7,608. The average is up 36% to date. But it remains well below where it was in April 2001, when Koizumi came to power. Skeptics also caution that what's good for the share prices of Japan's biggest producers isn't necessarily good for the rest of the economy. In contrast to the U.S., where firms have lowered costs through gains in productivity, many of Japan's big manufacturers have reduced overhead simply by shifting capacity to China. That boosts earnings and frees up cash but sucks jobs and spending power out of Japan's economy. Meanwhile, at small and medium-sized firms that employ the vast majority of the Japanese labor force, productivity and profit continue to slide.

Japan's big manufacturers can't spend money on new factories indefinitely unless someone buys their products. Yet Japanese consumers, who account for 55% of demand, aren't up to the task. Typically, in tough times consumers reduce spending and increase savings. When restraint finally gives way to pent-up desire to buy, the economy bounces back. Japan doesn't fit the pattern. Incomes have been shrinking for years, but rather than curtail their lifestyles, Japan's consumers are drawing down savings. Indeed, many economists believe Japan's household savings rate, which exceeded 20% in the 1970s, has tumbled below 6% and may soon plunge below the savings rate of spendthrift consumers in the U.S. While many will indulge in high-profile luxuries--a pricey watch, a designer handbag, the latest mobile phone--they balk when it comes to big-ticket items like cars. UFJ Tsubasa Securities economist Takeshi Minami warns that larger paychecks may not translate into higher sales because "consumer sentiment is fragile."

Can buyers abroad pick up the slack? Analysts expect Japan's global trade surplus, which contracted to $39 billion in the first half of this year, to recover in tandem with the U.S. economy. But a stronger yen would eat into export earnings by making Japanese goods less competitive in the U.S. and other countries that peg their currencies to the dollar. Japanese officials have spent $80 billion so far this year intervening in global currency markets to keep export earnings and surging foreign demand for Japanese stocks from pushing their currency beyond 115 yen to the dollar. That task is harder following the Dubai meeting, at which rich-country finance ministers extolled exchange-rate flexibility. Japanese officials have warned repeatedly that there has been no change in Tokyo's currency policy since Dubai. Exchange rates should "stably reflect fundamentals," declared Koizumi's new Finance Minister, Sadakazu Tanigaki, in his first meeting with reporters. "It is internationally recognized that it's acceptable to take action to make sure that happens." Traders don't seem cowed. Since Dubai, they have pushed the Japanese currency to around 110 yen to the dollar--not fatal to a Japanese recovery, but hardly helpful either.

Even the most effusive optimists struggle to spin Koizumi's reelection as proof Japan is finally getting its act together. The lion-maned leader is still a popular figure, with an approval rating of more than 55%. Yet he has failed to deliver on any of the economic policies he championed when he took office. Despite much-touted pledges to privatize the nation's postal system and scale back semipublic highway trusts, bureaucrats remain free to use both institutions to divert trillions of yen in public savings to pork-barrel construction projects. Koizumi has done nothing to address the problem of Japan's baby dearth or shore up its underfunded pension system. In March, Koizumi breached his vow to cap deficit bond issuance at $270 billion a year. During his tenure, spending on public works has declined by about 3% a year, but the national debt has ballooned to 140% of GDP, from 130%.

"Koizumi has given us enough slogans," complained Asahi Shimbun in an editorial. UBS Securities political analyst Shigenori Okazaki argues that although Koizumi talks constantly about reform, his LDP colleagues are content to let him remain in power "because they know he won't do anything to achieve it."

Investors were heartened by Koizumi's decision to reappoint Takenaka as head of the Financial Services Agency, as well as Economics Minister. But since last October, when LDP elders gutted Takenaka's bank-restructuring plan with Koizumi's tacit consent, the baby-faced economics professor has become more a symbol of Koizumi's infatuation with the idea of reform than an actual agent of change. Investors are still puzzling over the implications of Takenaka's May decision to spend $17 billion of taxpayer money to purchase a stake in Resona Bank, Japan's fifth-largest lender, effectively putting it under state control. Takenaka dismissed top management and forced the bank to tighten accounting standards and come clean on problem loans. In many ways the move was an old-fashioned government bailout. Notably, the companies that squandered their loans from Resona remained in business, and since the rescue, share prices of the bank's wobbliest borrowers have soared. That outcome reflects an entrenched preference throughout Japan to "restructure" by giving unprofitable borrowers more capital, or shifting liabilities from one ledger to another. Critics say that's a key reason corporate bankruptcies have been falling for the past eight months.

Although many have lost faith in Koizumi and Takenaka, some optimists look for relief from Toshihiko Fukui, the newly appointed governor of Japan's central bank. Like his predecessor, Masaru Hayami, Fukui has held interest rates at zero but resisted pleas to revive the economy by revving up bank printing presses and cranking out more money. Merrill Lynch's Koll argues that under Fukui's leadership, the Bank of Japan has experimented with a host of other unorthodox policies--including direct equity purchases and loans to small and medium-sized companies and semi-public corporations--that may yet prove hyperinflationary. So far, these measures seem to have had little discernable effect in boosting asset prices or stemming the four-year decline in consumer prices.

Koizumi swept into office chanting the mantra that Japan's economy would have "no growth without structural reform." As it turns out, voters are getting a smidgen of growth with almost no reform. It's not ideal, but things could be a lot worse. So go ahead and run with the bulls awhile. Just try not to get trampled in the stampede for the exits.