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How Long Can The Nikkei Run Last?


Fast money. bloated trading volumes. Soaring prices. Is Japan's financial community in some kind of collective flashback to the '80s? The Nikkei 225 index hit a five-year high of 15,778 on Dec. 13, up 37% year-to-date. That smokes the Standard & Poor's 500-stock index, which has seen a paltry 4% gain over the same period. In November volumes were so heavy they contributed to a crash of the Tokyo Stock Exchange computer system. Interest is so hot that Daiwa Securities Group () has started offering podcasts of daily stock market action to lure tech-savvy young Japanese, who trade from their Web-linked cellular handsets. "We are putting more muscle into our mobile-phone service," enthuses Takeru Suzuki, head of investor relations at E*Trade Japan ().

Hold on. Isn't this the market that saw three big sucker's rallies during the 1990s? And didn't the Nikkei crater to a 20-year-low of about 7,600 just two years ago? Yes, but that hasn't stopped the frenzy. The "Buy Japan" cry from U.S. funds and scores of stockpicking newsletters is deafening. Foreigners have spent more than $78 billion on Japanese stocks this year, a wave of capital not seen since '99. Some say they have good reason: The expansion that started in 2002 seems to have legs. The economy is on track to grow 2.5% in 2005. Barclays Capital () economist Takuji Aida sees 2%-plus gains in 2006 and 2007. If so, Japan is in the midst of the "longest growth period in the postwar era," he says. "We expect the stock market to keep rising."

LOFTY VALUATIONS

Not to be churlish, but a bit of caution might be in order. Kathy Matsui, Goldman Sachs Japan's () generally bullish equity strategist, expects an 11% gain in the broader Topix Index by yearend 2006. Not bad, but far from this year's performance. Japanese stocks sport price-earnings ratios of 26 times forecast 2006 earnings, vs. 16.5 for S&P 500 shares. And the S&P boasts twice the dividend yield, on average. "Japanese equities are no longer undervalued," as they were a couple of years ago, says Credit Suisse First Boston () analyst Satoru Ogasawara. His colleagues in London on Dec. 9 urged clients to cut their investment weighting in Japan, citing lofty valuations that suggest the market is overbought. Meanwhile, the iShares Japan Index Fund (), a popular $10 billion exchange-traded fund managed by Barclays Global Fund Advisors, was one of the most shorted issues on the American Stock Exchange last month.

Another red flag: the mix of stocks in Japan. The Nikkei has lots of cyclical multinationals such as electronics components maker TDK () Corp. and Honda Motor Co. () that could quickly slip during an unexpected slowdown in China or the U.S. About 40% of the market capitalization of Japanese-listed stocks is from such issues, vs. 30% in the U.S., SG Cowen & Co. figures.

Then there's the Japanese economy. Sure, the turnaround is real. The banking sector has shed most of its bad debt, and the Bank of Japan is unlikely to repeat its blunder of 2000, when it boosted interest rates too soon and hurt a nascent recovery. But Japan Inc. is still burdened by red tape and high fixed costs, and earnings and share-price increases remain closely tied to productivity gains. While Japanese companies have burned off excess debt, capacity, and labor in recent years, they're still behind rivals in the U.S. and Europe. And profit growth for Japanese companies, though still robust, is slowing.

And what happens if the foreign money cascading into Japan dries up? In the past that has always ended Nikkei rallies. Lost in the mania is the fact that domestic investors have been net sellers during this rally. Crazy as it seems, most Japanese keep their savings in bank accounts and low-yielding time deposits managed by the postal system.

For some, that's a plus. Lehman Brothers Inc. () economist Paul Sheard thinks a "wall of money" will tumble into stocks once Japan's price deflation ends in 2006 and a real estate recovery strengthens enough to give domestic players the confidence to invest in stocks. But similar predictions a few years back didn't pan out, and when foreign money skipped town in 2003, the market swooned. Buyer beware: Investing in Japan can be heartbreaking. Just look at the '80s.

By Brian Bremner and Roben Farzad


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