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Japan’s rally: Stocks need more than central bank fuel Add to ...

Japan’s stock market is racing ahead this year – but it is only natural to wonder if the gains have any staying power.

So far in 2013, the Nikkei 225 has risen 36 per cent, making it the world’s best-performing major index even when you put the returns in U.S. dollar terms (at 19 per cent). And since mid-November, the gains are closer to 64 per cent.

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But the Japanese market hasn’t been known for sweeping upward trends over the past 20 years, being far more prone to follow a step forward with two steps back – rewarding investors who cash out after quick gains.

This latest rally has some differences, though. For one thing, it’s huge: According to Bespoke Investment Group, the year-to-date gains are the biggest going back at least to 1970. That suggests that this rally is more than a blip with little momentum behind it.

Indeed, it is likely being fuelled by some powerful forces – led by a newly invigorated central bank that is borrowing a play from the U.S. Federal Reserve. The Bank of Japan is now resorting to a bold round of quantitative easing, the unconventional policy of buying massive amounts of government bonds to stimulate the economy and, it is hoped, raise the country out of years of deflation. It also doubled its official inflation target to 2 per cent.

The scale of the central bank’s actions, noted The Economist, “marks a decisive break with the past.”

Yet, it remains unclear whether the moves will succeed. The Fed has been using quantitative easing (or QE) for years, but the impact is open for debate. Gross domestic product expanded a disappointing 2.5 per cent in the first quarter, at an annual rate. In the Fed’s most recent monetary policy statement, it said unemployment remains “elevated” and inflation is running below the longer-run objective.

The impact of the Fed’s QE on the stock market, though, is far more dramatic: The S&P 500 has risen some 140 per cent from its low in 2009 – and a monetary policy that encourages risk-taking and boosts corporate profits has likely contributed significantly to those gains.

If Japan’s stock market follows the U.S. example, then the gains are likely to continue if the central bank follows a consistent, long-term plan for adding economic stimulus. After all, the QE-fuelled S&P 500 has been rising for more than four years.

But the U.S. gains have done little to banish concerns about what happens when the stimulus ends. Bearish observers such as John Hussman remain convinced that the S&P 500 is at risk of a potentially sharp setback because it has become dangerously overextended. At the same time, small investors remain cautious about stocks, and continue to direct money into bonds.

Japanese stocks have responded well to economic stimulus. For the gains to stick, though, the economy is also going to have to respond.

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