Japan stocks, caught in the crossfire, may be ripe for value hunting

The Globe and Mail

The Nikkei 225 has slumped into yet another bear market, and you can almost hear the told-you-so’s from those observers who have sworn off Japan for its habit of crushing optimism over the past two decades. But while Japan is down, it is not out.

Stocks there have certainly gone on a wild ride. After rising to multi-year highs in May as part of an 80 per cent surge in 2013, the Nikkei has now fallen about 22 per cent from its intraday peak, conforming to the popular definition of a bear market. It fell 6.4 per cent in overnight trading on Thursday, reducing its year-to-date gains to just 20 per cent.

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No doubt, some investors see this stunning reversal as a vote against the country’s efforts to shake off years of deflation and a stumbling economy. The election of Shinzo Abe as the country’s prime minister brought a dynamic plan – dubbed Abenomics -- to make economic reforms and provide enormous stimulus. The Bank of Japan is on board with its own monetary policy stimulus.

However, the stock market’s downturn has little to do with the success or failure of Abenomics: It is simply too early to tell whether the stimulus is working. Instead, the downturn is tied to wider market gyrations largely tied to the United States.

Japan’s downturn followed a shift in sentiment toward the Federal Reserve, where many now believe the central bank will start to slow purchases of Treasury bonds and mortgage-backed securities later this year. That shift has driven U.S. government bond yields higher, threatening to end a 30-year-old bond bull market.

The impact has moved well beyond the United States, though. In China, the Shanghai stock exchange index has fallen to a six-month low. Small economies are also being hit. On Thursday, the Philippines benchmark index fell 6.8 per cent and Thailand also fell.

"Investors have spent several years allocating to emerging assets with liquidity from quantitative easing," Kenneth Akintewe, a portfolio manager of local currency Asian bonds at Aberdeen Asset Management Asia, told the Wall Street Journal. "Now they are arguably overreacting to a possible reduction in policy stimulus, although the Fed's not going to take it away any time soon."

That makes Japan look like as though it is being caught in the crossfire – and therefore a tempting buy should the country’s stimulus plans pay off. Risky? For sure, but you wouldn’t be alone.

Strategists at Nomura (via FT Alphaville) raised – yes, raised – their year-end target on the Nikkei 225 to 18,000, up from their previous target of 16,000. That implies a gain of about 44 per cent from the index’s current level.

Their reasons for ratcheting up their bullishness in the face of a bear-market correction? They believe earnings are now recovering and stocks will also get a valuation boost from a rise in global price-to-earnings ratios.

“We think the full impact of Abenomics on capex and household incomes has yet to be felt, which means that there are still substantial investment opportunities in these areas,” they said in a note.

But there is a note of caution with their enthusiasm: Right now, the Nikkei 225 is just 50 points above where it began on April 3, when the Bank of Japan announced its bold monetary policies to provide stimulus, putting it at a pivotal point. If stocks fall below that level, the Nomura strategists argue, observers could pronounce Abenomics a failure.

“If Japan returns to square one despite this new phase of monetary easing, we think this will be a tragedy for the Japanese stock market,” they said.