TOKYO -- A confluence of factors contributed to the Nikkei Stock Average's recent 12-day winning streak, the longest rally in 27 years, and to the yen's slide to its weakest level against the dollar in 12 and a half years. But the most significant driving force in these epic market events is a widening gap in the monetary policy stances of the Japanese and U.S. central banks.
Monetary policymakers, of course, are reacting to the health of their economies. While the U.S. Federal Reserve is preparing to wind up the radical easing program it introduced in the wake of the 2008 collapse of Lehman Brothers, the Bank of Japan is showing no signs of ending its "new dimension" in monetary easing, announced in 2013.
Ferraris and Hermes
The benchmark Nikkei index hadn't gone on a 12-day ride since 1988. It was enjoying the bubble back then, and share prices would keep rising to 38,915 by the end of 1989. In those days, it was said, the total value of land around the Imperial Palace was higher than all the real estate in the U.S. state of California.
Tokyo stocks also recently hit another milestone. Last month, the total market capitalization of all the stocks listed on the First Section of the Tokyo Stock Exchange surpassed the bubble-era record logged at the end of 1989.
Do these facts spell b-u-b-b-l-e? Not necessarily. At least the speculative frenzy that gripped the nation during the go-go days of the late 1980s is absent.
Japanese listed companies posted record profits for the year that ended in March and are widely seen as on their way to another banner year. The average price-earnings ratio of TSE First Section stocks is a relatively modest 17, compared with over 60 at the end of 1989.
But there is no denying the current stock rally is a result of excess liquidity sloshing around the world economy. Both the global financial crisis that started in 2008 and the European debt crisis since 2010 prompted the central banks of major countries to inject huge amounts of cash into their economies, thereby alleviating investor anxiety.
The central banks of the U.S., Europe and Japan now hold nearly $10 trillion in assets among them, more than double the amount before the Lehman shock. They have purchased a tremendous amount of government bonds and other securities in an effort to flood financial systems with cash.
The negative interest rates that emerged in Europe were a product of central banks' massive purchases of government bonds amid extremely low yields.
The consequent global liquidity glut has pushed up the prices of products that carry a certain exclusivity. Last year, a 1962 Ferrari 250 GTO was sold at auction for a record $38 million. This week, a fuchsia Hermes Birkin bag with diamonds was sold for a record 1.72 million Hong Kong dollars (more than $220,000) at Christie's auction in Hong Kong.
A lot of this good-times money is also flowing into stocks. The Dow Jones Industrial Average rose to a record last month. Even in China, where the slowing economy is causing great headaches, the Shanghai stock market index has more than doubled in the past year. Japan's stock market run-up has also been driven by factors other than Japanese companies' swelling profits.
The central banks at the root of it all have only been trying to provide a kick to their stock markets. In 2010, when the Fed started its second round of quantitative easing, then Chairman Ben Bernake argued in The Washington Post that easier financial conditions would promote economic growth by shoring up the stock market. "And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending," he wrote.
But now, with confidence apparently boosted, the end of the Fed's quantitative easing road is in sight. The Fed is readying itself to tighten its monetary policy for the first time in nine years. What is speculation about a rate hike by the end of the year doing to investor confidence? On May 26, the U.S. stock market tumbled.
Expectations, meanwhile, are pushing up Japanese stocks. After the Fed raises interest rates, the BOJ will continue its easing, according to common wisdom. This dynamic would provide a strong incentive for investors to chase higher returns by piling into the U.S. dollar. A stronger dollar would mean a weaker yen, and that would mean even fatter earnings for Japanese exporters.
A lot of investors have already placed their bets that this will play out.
Japanese stocks and the country's currency are racing in opposite directions because monetary policies in Japan and the U.S. are also on divergent paths. The Fed wants to respond to the recuperating U.S. economy, while the BOJ is still trying to get the Japanese economy out of its sickbed.
So three cheers for Japan's stock market rally. Just hold off on any enthusiasm for the rest of the economy, which still faces numerous potential risks.
Even on Wall Street, things are not so rosy; there is a lot of talk about a major correction. Goldman Sachs recently published a research piece asking if market valuations are in "dangerous territory."
Since March, money has constantly flowed out of investment funds focused on U.S. stocks. There are signs that many investors there are getting out now while the getting is good.
Time now for radical reforms
Even Tokyo is taking off its rose-colored glasses. Part of the reason is to see what's happening in China more clearly. Is the economic slowdown there threatening to knock Japanese stocks off their upward trajectory?
In a recent survey of market players in Asia by AlixPartners, a U.S. business consultancy, 93% of the respondents predicted that more companies will have to restructure their businesses in response to China-related factors.
Japan's stock market would take a massive hit if the Chinese economy comes in for a hard landing -- or if U.S. shares tumble.
We should also not forget the lessons of financial crises in emerging countries being triggered by U.S. monetary tightening.
The key question is whether Japanese companies have acquired the ability to keep growing were such negative conditions to take hold.
Learning from history, of course, is not enough. Rather, Japanese executives should be using the powerful bull market in their home country to push through radical, future-oriented reforms.
Those that do will be better able to keep their shares at lofty valuations when all the excess cash now buying Ferraris and Hermes begins to dwindle.