Is Now A Good Time To Invest In Japan’s Stock Market?

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Is Now A Good Time To Invest In Japan’s Stock Market?

Japan’s stock market has surged in 2017 to its highest level in 21 years. Does the rally still have room to run?

Published on 11 December 2017

In the past year, Japan’s benchmark Nikkei 225 index has gained about 20% to reach its highest level in 21 years. During one stretch in October, the index rose for 16 consecutive sessions – the longest winning streak in its 67-year history. Over a five-year period, the Nikkei 225 has climbed by around 140%.

The Nikkei 225 is considered to be a barometer of Japan’s economic performance as it includes the country’s biggest and most well-known companies.

Strong global growth and an export-led economy have contributed to the rise in the index. Japan’s gross domestic product (GDP) has been increasing at a steady pace in the recent past. The recently announced figures for the July-September quarter show that the country’s GDP grew at an annualised rate of 2.5% during these three months. Japan’s economy has registered seven consecutive quarters of growth – the longest stretch on record.

The Organisation for Economic Co-operation and Development (OECD) – an intergovernmental organisation with 35 member countries – estimates that Japan will register growth of 1.5% in 2017. In 2018 and 2019, the economy is forecast to expand at a slightly slower pace of 1% per year.

Investors who bought into the Japanese stock market through an exchange-traded fund (ETF) that tracks the Nikkei 225 would have made a significant level of gains over the past five years. But if you have don’t have exposure to Japanese stocks in your portfolio yet, should you invest now?

Although Japan’s economy and many of its world-class companies are doing well, some analysts think that the rally in the country’s equity market may have run out of steam and that a correction may be on the horizon.

Other analysts, however, point out that that the rise in the Japanese stock market is backed by solid economic growth and an increase in per capita output over the past five years.

Understanding the rise in the Nikkei

Japan, Nikkei 225, invest

The Nikkei 225 is a price-weighted index. This type of index is calculated by giving a greater weight to the price of a share. To understand this method, consider a price-weighted index that has only two shares, one that is priced at US$1 and the other at US$10. The US$10 share will have a weight that is nine times more than the other company.

An index based on market capitalisation works differently. In this method, the weight of a company is determined by its market capitalisation, which is the price of its share multiplied by the total number of shares. The S&P 500 index is calculated using the market cap of its component companies.

The biggest companies by market cap in the Nikkei 225 are familiar names such as Toyota, Honda Motor, and Sony.

Top 10 Nikkei 225 Companies By Market Value

But the companies that have registered the largest gains in their share prices are lesser-known names.

Top 10 Nikkei 225 Gainers In 2017

Why does this matter? The method of calculation of the Nikkei is important because a smaller company that sees a rapid rise in its share price could have a disproportionate effect on the index. Toyota – which has a market cap of over US$200 billion – has a weight of 1.22% on the index. Yaskawa Electric, a company with a market cap that is approximately 5% of Toyota’s, has a weight of 0.66%.

It is also interesting to note that over the years, the ownership pattern of Japanese stocks has undergone a drastic change. The chart below illustrates that financial institutions now hold a relatively lower share in the ownership of Japanese stocks. Similarly, Japan’s retail investors’ holdings have also declined. Foreign investors now own a much greater part of Japanese companies.

Although the increasing inflow from foreign investors is a positive sign, it could be a disadvantage for Japan’s market too. If the Nikkei 225 declines, it may result in overseas investors pulling out of the market as quickly as they had entered.

Another factor that cause potentially a sharp downturn in Japan’s stock market is North Korea’s nuclear programme. In July, August, and November this year, ballistic missiles were fired by North Korea in the direction of Japan and landed in the sea.

While these incidents did not have a significant impact on Japan’s stock market, the threat of a nuclear war could have major repercussions in the future for the country’s security and economy. If the war of words between North Korea and the US escalates into a real conflict, Japan is likely to be severely impacted.

Japan’s ageing population

Japan, Nikkei 225, invest

According to the World Economic Forum, a not-for-profit foundation headquartered in Geneva, Japan’s demographics will pull the country’s GDP down by an average of 1% a year over the next three decades. While the rise in the number of non-working citizens is an issue that many countries face, the problem is most acute in Japan.

The 2015 census revealed that 26.7% of the country’s population of 127 million is over the age of 65. The government estimates that by 2030, the number of workers in Japan will fall by 7.9 million. By 2060, the population will fall to 86 million with those over 65 comprising 40%.

The problem for the economy is serious with no immediate solution in sight. One in four men and one in seven women had yet to get married at age 50 at the time of the 2015 census. The number of children in the country is falling and in every one of the 47 prefectures in Japan, people over the age of 65 outnumber those less than 15 years old.

In addition, Japan has a very strict immigration policy. Its young population cannot be increased by allowing overseas workers to enter the country. One solution that is of some help is the increased use of robots in the country’s manufacturing plants. Robots are even being used to carry out some of the tasks related to caring for Japan’s elderly.

But there is no getting away from the fact that over the medium- to long-term, demographics will play an important role in determining the nation’s economic future, and the diminishing size of the country’s workforce will have a negative impact on the productivity and profitability of its companies.

The bottom line

Even though the Nikkei 225 has registered a significant gain, its current level is nowhere close to its all-time high of 39,000, which it achieved in 1989. Since that time, Japan’s premier stock market index has not even managed to come close to cracking the level that it reached 28 years ago. Despite several false starts over this period, the Nikkei 225 has been unable to sustain its upward trajectory for any length of time.

So, will this year’s rally last? Time will tell, but Charles Gave – an expert in tactical asset allocation and a stock market veteran of over 40 years – seems to think so. In an interview to the Nikkei Asian Review in November, he said that this rally is different, “I am decisively bullish on the Japanese equity market. I will remain invested as long as the [positive signs] remain in place.”