The financial markets of Japan have experienced some exciting changes over the past 20 years. They were once a global force and issued many large and successful blue-chip companies such as Toyota, Canon, and Honda.
However, following two major asset bubbles in the late 1980s and early-1990s, their market has gone through an extended period of sideways consolidation for roughly twenty years, commonly known as the ‘lost decades’. (Note that this is not to be confused with the US ‘lost decade’, which lasted from 2000-2010).
However, in the past couple of years, something rather remarkable has happened – Japanese stocks have been outperforming most other world equity markets.
The Nikkei 225 index has been up more than 60% since its low point in 2008, and the Topix index is up over 100% since its low end in 2009.
Japanese stock markets have seen a remarkable turnaround – but what’s caused it? At first glance, it may seem like a positive change in fiscal policy has led to investors re-thinking their views on Japanese stocks, such as the aggressive quantitative easing (QE) that Japan’s central bank has enacted, or perhaps an improvement in corporate profits due to the strength of Japan’s export market.
However, closer inspection suggests this could be an example of yet another asset bubble following the classic pattern. So how much further does this one have left to run, and where might we see future valuation peaks?
The case for bullish markets
The Nikkei 225 has been a great performer since mid-2012, up over 85% since then. However, the market began to surge in the second half of last year as this first chart shows:
You can see there was a substantial change in trend from September 2012, and it’s clear that other indices around the world have not matched this performance. So what caused this surge?
There is no obvious answer, but QE is associated with low-interest rates, so perhaps this is part of it.
Long term investors will be more interested in earnings than revenue growth, though and revenues for listed companies increased by just 0.5% in the quarter to September. More investors are expecting earnings growth, though, so this is another reason for speculation.
Japanese companies with the most robust financials have performed well, but smaller stocks that were most heavily sold off during Japan’s prolonged bear market have also done very well.
This includes some large companies – NTT, Takeda Pharmaceutical and Mitsubishi- all with quarterly dividend yields of 4% or more.
So it appears that not only has this market rally been driven by strong global equity markets generally, Japanese investors may be feeling optimistic about their economy again as there is evidence that business confidence is high with 85% of listed companies showing positive profit expectations (compared with 45% percent in mid-2012).
There seems to be a feeling that improvement in economic sentiment has been boosted by the recent rise in stock prices, leading to a virtuous cycle of optimism.
The case for Bearish markets
While Japan’s equity market performance might look impressive, it is still significantly below the highs seen nearly twenty years ago, and there are some excellent reasons why this should not continue to head higher from current levels.
The Nikkei 225, as noted earlier, is up over 60% since its lows back in 2008 but compared with other world markets, that’s nothing special – US indices have risen five times faster since their low point.
In fact, despite QE being implemented by all major central banks around the world, including the Bank of England and the FederalReserve, Japan is doing worse than most of them.
It may be reasonable to think that the yen would weaken if inflation were expected to rise. We can see here that while there has been a slight improvement in sentiment since mid-2012, it’s still very much lagging behind other major global economies.
This suggests that Japanese investors are not convinced by this recovery, or perhaps they remain pessimistic about the prospect for their economy over the next decade. Many foreigners have long left Japan as an attractive market because of its low growth prospects. Still, now domestic investors are beginning to go too – one reason being made clear by money flows out of Japanese equity funds reported monthly by Japan’s Ministry of Finance. Such outflows had followed stock price declines over the last year, with cash flowing in before the market peaked.
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