Japanese Stocks Surging: Time to Buy

Japan's Stock Market Surges to New Heights

Japan’s stock market has recently reached new record highs, offering investors an additional opportunity to diversify their investment portfolios. The Nikkei 225, one of the country's most prominent stock indices, has closed at seven record highs this year alone, with three of those occurring in just the past week. This impressive performance has seen the index rise by 14% so far this year.

This surge marks a significant turnaround for the Nikkei, which only recently reclaimed its 1990 high last year. However, it was not long before sellers stepped in to push the index lower. This summer, though, the index finally broke through to new heights, signaling a potential shift in market dynamics.

Breakouts often indicate a change in market sentiment, drawing in more buyers at levels that previously saw strong selling pressure. Julian Emanuel, a strategist at Evercore, describes the Nikkei’s recent gains as “suggesting a durable upswing.”

Economic Growth and Inflation Trends

Japan’s economy is showing signs of growth, with projections from FactSet indicating that real gross domestic product (GDP) is expected to increase by nearly 1% annually over the next two years. Despite previous concerns, such as the impact of Trump-era tariffs, these expectations remain intact.

Japan’s economy is heavily reliant on exports, but only a small portion—less than 4% of GDP—comes from trade with the United States. This relatively low dependency on U.S. exports helps insulate the Japanese economy from external shocks.

Inflation has also been on the rise, marking a departure from years of near-zero inflation. The consumer price index has increased over the past two years and is expected to continue growing, albeit at a slower pace of just under 2% over the next two years. This trend reflects companies raising prices and maintaining stable consumer demand.

Interest Rates and Bond Yields

With this economic expansion, the Bank of Japan’s policy rate stands at 0.5%, and it is projected to rise to 1% in the coming year. This shift brings rates into positive territory, a sign of a healthy and growing economy. However, the rates are still low enough to support both consumers and financial markets.

The yield on Japan’s 10-year government bond currently sits at 1.6%. This relatively low yield gives investors confidence to continue investing in equities, especially if they anticipate higher returns compared to bonds.

Corporate Governance and Investment Opportunities

Recent changes to corporate governance standards in Japan have further bolstered investor confidence. These reforms have encouraged companies to increase dividends and stock buybacks. Buybacks can boost earnings per share, leading analysts to predict a 10.5% annual growth in earnings per share over the next two years.

Additionally, Japan has raised the tax-free investment limit for stocks, unlocking more capital for the market and supporting stock prices. Currently, approximately $9 trillion is held in cash and cash-like investments in Japan, representing more than 75% of the total value of the country’s stock market.

Valuations and Investor Sentiment

In most countries, cash holdings are a small fraction of equity investments. In the U.S., for example, cash makes up single-digit percentages of investors’ equity holdings. This contrast highlights the potential for more money to flow into the Japanese market.

Moreover, valuations in Japan are not considered expensive. The Nikkei 225 trades at 19.9 times expected earnings per share for the next 12 months, significantly lower than the S&P 500’s multiple of nearly 23 times. This discount provides a compelling reason for investors to consider Japanese equities.

The Nikkei’s price-to-earnings ratio suggests that an investor would receive a 5% return on their investment, which is more than 3 percentage points above the yield on the 10-year Japanese bond. This premium compensates investors for the added risk associated with equities.

A Strong Case for Diversification

From Japan’s economic growth to its inflation trends, interest rates, idle cash, and stock valuations, the case for investing in the Nikkei 225 is strong. For investors looking to diversify beyond the S&P 500, the Japanese market offers a promising opportunity.