On Chinese New Year eve, I had a call with one of my Chinese friends and she asked me where to invest our money in 2024. I said: “First of all, if you have any investments in the Chinese portfolio, dump them immediately. Instead, consider investing in the S&P 500 Index. While this may seem like a no-brainer strategy, it is the most rational one given the current circumstances. We are entering the AI era and witnessing one of the most significant turning points in human history. The Magnificent Seven, which possess unparalleled advantages in the AI boom, constitute more than 30% of the S&P 500." Then she asked: “What about the Nikkei Index?”
That was a really good question. If your investment horizon is just one year, I would say go ahead and put your money into it as there are several catalysts that will have a positive impact on the market. However, if you are a long-term investor and want to invest a certain amount of money regularly, you need to conduct thorough analysis and consider whether the market is undergoing a fundamentally positive change.
I decided to conduct a bottom-up analysis on the Nikkei Index, starting with Nikkei 225 trading data.
The Nikkei 225 Index reached a record high in February 2024, realising a year-over-year increase of 42.46%. However, unlike the S&P 500, it lacks a consistent track record of sustainable growth. Over the past 24 years, only 13 (approximately 54%) have seen year-over-year growth, whereas the S&P 500 managed increases in 17 out of 24 years (approximately a 71% chance).
The Nikkei 225 has been traded at a relatively low P/B ratio compared to the S&P 500, implying that it's much cheaper than the S&P 500. This situation makes sense since American tech giants have attracted investors’ attention, and people have more confidence in the US economy than in Japan’s.
Components Analysis
To analyse whether the rally in the Nikkei Index reflects fundamental growth, we need to examine the operational and financial conditions of its components.
I have selected the top-7 components in the order of their market caps to check their critical metrics. It is evident that most components have been able to maintain their operating margins and achieve growth in net income despite the pandemic-induced challenges. the steady increases in ROE indicate that most companies are utilizing their equity capital efficiently. However, it is notable that the growth in profits is primarily driven by offshore demand and although most companies are performing well, they have not passed on the profits to their employees' wages. This lack of wage increases has resulted in a drag on domestic demand.
Capital Sources & Macroeconomy
The graph from Bloomberg shows that the rally in Japan’s stock market is driven by foreign capital, while confidence in Japan’s economy among domestic investors remains low. This can be attributed to disappointing macroeconomic indicators. In Japan, inflation persists above the 2% target, while the wage growth rate lags behind inflation. Moreover, Japan is among the most indebted countries, with a debt to GDP ratio exceeding 200%. If the government begins to raise interest rates in 2024 as hinted, the substantial increase in interest expenses could compel the government to raise taxes and reduce expenditures.
Catalysts
There are couple catalysts that can explain the significant inflow of foreign capital:
(1) China’s property crisis
(2) The potential bubble in US stock market
China has been experiencing economic turmoil due to the collapse in the real estate sector. This struggling economic performance has spooked offshore investors, leading them to rethink their investment strategies in East Asia. Attracted by the weak Yen and surprisingly high EPS, these offshore investors are redirecting their capital to the Japanese market. The stock price growth graph from Bloomberg below can illustrate a potential negative correlation between the performances in Japan and China.
Also, investors, concerned that the US stock market may be overheated and overconcentrated, tend to invest in Japan’s stock market to diversify their portfolio risk.
Conclusion
In a word, I don’t think it’s an illusion because it’s driven by the companies’ performance, cheap stock prices, and the dynamics in global market. However, it's certainly not a fundamental turning point either. Shrinking labour and wages, weak domestic demand, and indebted government make it difficult to reverse the situation. In the foreseeable future, I anticipate the index price will continue to rise due to the companies' earning performances and the catalysts I mentioned. You can consider including Japanese stocks in your investment portfolio to diversify risk over the next two years, but I wouldn't recommend solely investing in this market for the long term.
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