August 22, 2014 7:00 pm JST

Japan stocks may repeat 2005 bull run

YOICHI NAGAI, NQN senior staff writer

TOKYO -- Japan stocks are showing a firm floor, but their upside will be limited, according to most market players. Although forecasts based on current trends could prove incorrect, domestic stock prices seem to be a good gauge of the economy's future performance.

     If the market consensus is accurate, the benchmark Nikkei Stock Average could be quietly headed for this year's record high in anticipation of a genuine recovery in the Japanese economy starting next year. Some observers say the picture looks much the same as it did nine years ago, when the stock market went on a bull run. 

Still gun-shy

Asked how far the Nikkei index will rise by the end of the year, market watchers sounded less confident. One predicted it will top out no higher than 16,500, while another said it will climb to 18,000. But the prevailing view among market participants is for a ceiling of 17,000. That is up 10% from the current level, and not bad from an asset-management perspective.

     Still, that prediction is disappointing in light of the ample positive factors in the market at the moment. In Japan, many companies are seeing solid earnings, and the government has taken steps to support stocks ahead of a second consumption tax hike scheduled for October 2015. In addition, the U.S., economy, on which Japan still relies heavily for its own growth, is picking up thanks to stronger job numbers, business sentiment and home sales.

     Market players remain cautious about the outlook for Japanese stocks, uncertain about the effect of an expected rise in U.S. interest rates next year. Hirokazu Kabeya, senior strategist at Daiwa Securities, said that the U.S. is enjoying the best of both worlds -- ultralow interest rates and expanding corporate earnings -- but that those days are coming to an end.

     Higher interest rates do not always hurt stock prices, as they can reflect a recovering economy. Theoretically, a stock's future price can be calculated by dividing the company's earnings outlook by the interest rate. Thus, textbooks say stock prices fall when interest rates rise. A downtrend on Wall Street could make Tokyo stocks top-heavy as well.

     The Japanese economy remains under a cloud, amid lingering concerns about the effect of April's consumption tax increase. Preliminary April-June gross domestic product figures showed an annualized 6.8% drop. Economists are expecting a 4% rebound for the three months through September. But Japan been hit with torrential rain across the country since the beginning of August. The inclement weather could hurt consumer sentiment.

Positive signs

The stock market is a good indicator of economic performance three to six months down the road. This can be seen by looking at the relationship between real GDP growth and the Nikkei index since 1994, where 1 indicates absolute correlation and -1 indicates complete negative correlation -- the two moving in opposite directions -- The overall correlation between real GDP growth and the stock index was 0.395. Over a three-month time frame, the correlation was 0.507, rising to 0.512 six months out. By one year, the correlation fell to 0.275. The data thus points to the Nikkei Stock Average as a good medium-term gauge of economic growth.

     Based on this, the expectation that Japan's economic slump will continue through September appears to have been factored into stock prices, as the Nikkei index fell to 14,000 in late May from nearly 16,000 at the beginning of the year. The index, which has been edging higher of late, seems to point to an economic recovery starting this summer, as forecast by the Bank of Japan, thanks to improvements in employment and income.

Deja vu

The current negative factors are similar to those present from 2004 through the summer of 2005, including the previous U.S. interest rate hike, a small-cap stock boom and Japan's economic slowdown, said Masayuki Kubota, chief strategist at Rakuten Securities Economic Research Institute. He added the Nikkei index seesawed around 11,000 at the time.

     The U.S. Federal Reserve decided to raise its target for the federal funds rate in June 2004 for the first time in about four years, as the U.S. economy recovered. As the effect of very low interest rates wore off, U.S. stocks wavered but stayed in positive territory for a while before and after the interest rate hike. Then the U.S. economy expanded steadily before stocks started climbing further, in the second half of 2005.

     Japan's economy contracted in the October-December quarter of 2004 as consumers held back during an unusually warm winter. During this period, the economy plateaued. But a decline in the yen lifted earnings at Japanese exporters starting in the summer of 2005. Finally, Japanese stocks surged on hopes for reforms from Japan's prime minister at the time, Junichiro Koizumi. The privatization of Japan Post set off the rally.

     With this history in mind, Rakuten Securities Economic Research Institute's Kubota predicts the Nikkei index may move in a way similar to 2005. If this proves true, Japanese stocks will enjoy strong momentum beginning in November, and reach the 18,000 mark by next March. The institute surveyed 121 large Japanese companies, including financial firms, this fiscal year and estimated their pretax profits will climb by an average of 12% in fiscal 2014, based on their earnings for the April-June quarter. That exceeds the companies' own forecasts for a 0.3% increase and the market consensus of a 5.9% rise.

     In Japan, higher exports to the U.S. and elsewhere are likely in the second half of the year. Combined with other factors, including a full-fledged recovery in the U.S. and a growing gap in interest rates between the U.S. and Japan, the stock market looks set for its biggest jump since 2005.