John Templeton, the late, great stock picker, believed booms and busts come in four stages: "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." Perhaps no market is plotting this course more obviously now than Japan, the zigs and zags of which Templeton knew better than most. The mutual funds he pioneered invested in Japan well before the global herd in the mid-1960s. His four-step sequence played out in Tokyo in the 1980s, ending in a spectacular crash. Might this latest rally, one driving the Nikkei Stock Average to its highest levels since 1991, end badly too?
Only time will tell. Yet Japan's bull market has arguably entered the euphoria stage, one that economic realities might not support.
From a price-earnings ratio, an argument can be made that Japan is cheap relative to, say, the U.S. The Nikkei's 225 companies are, on average, trading at 17.5 times earnings. That compares with 19 for the Dow Jones Industrial Average.
A key difference, though, is that U.S. consumer demand is expanding, and corporate taxes were reduced 10 months ago, supporting rising earnings. Japan Inc. faces growing headwinds from an aging population, stagnant wages and slowing growth in China. Also, a not insignificant amount of Nikkei optimism relies on continued Bank of Japan monetary welfare. It is not a given.
The Nikkei boom has various drivers: the longest economic expansion since the 1980s; Prime Minister Shinzo Abe's moves to strengthen corporate governance; a yen that is weaker than CEOs anticipated; optimism that Japan can withstand Donald Trump's escalating trade war.
The problem for bulls is that each of these motors is running into fast-mounting difficulties.
The first, economic growth, has had its share of questioning in recent months. Case in point: a 0.2% contraction in first-quarter gross domestic product. The first quarter-on-quarter drop in nine gave way to a return to only modest growth of 0.7% in the second quarter.
All signals point to a fresh downshift, compliments of President Trump's "America First" tariffs. The Bank of Japan's "tankan" survey of large manufacturers just registered its third straight quarterly drop -- down two points to 19.
The downshift in China, Japan's main market, is gaining momentum. Two gauges of manufacturing activity worsened in September. Both Beijing's official purchasing managers index and a closely-watched one compiled by Caixin are on the verge of falling below 50, the point when they signal contraction. They stand at 50.8 and 50, respectively.
Moreover, deteriorating prospects for a truce between Trump's administration and Xi Jinping's in Beijing suggest more pain to come -- on top of the $250 billion of goods Trump targeted so far. For Japan, that is almost certain to translate into less investment, diminished demand and fewer wage gains of the sort Abenomics needs to thrive.
Next, a dearth of big reforms will haunt Abe in his third term. Had Tokyo moved faster to loosen labor markets, kick off a startup boom and incentivize companies to share the wealth, Japan would be less vulnerable to China's risks.
Abe's efforts since 2012 to internationalize business practices captured the imagination of many foreign investors. In 2013, for example, the benchmark surged a stratospheric 57% as foreign punters rediscovered Japan.
They are busy again, as evidenced by the Nikkei's 19.5% return over the last 12 months. Yet increased returns on equity are not enriching the broader economy. Wealthy owners of stocks and land are thriving. Average salarymen and women, not so much.
Unless Japan Inc. opens its wallet to give workers hefty raises, not just sporadic bonuses, future demand will not support today's valuations. Japanese companies are sitting on more than $2 trillion of cash. In July, real wages grew just 0.4% from a year earlier, dashing hopes the previous month's 2.5% jump was the start of a firm uptrend. The June gain all about one-time bonuses. If executives do not share the spoils of Abenomics, GDP growth could end abruptly.
Meanwhile, the weaker-than-feared yen is surely a plus. Though essentially flat versus the dollar this year at 113, many CEOs were bracing for a yen surge to about 105. But the benefits from exchange rates -- helping exports -- could prove fleeting.
For one thing, capital inflows as overseas investors seek shelter from chaos in emerging markets could be a harbinger of stronger yen. International punters bought the most Japanese shares and futures in four years in the third week of September -- nearly $13 billion worth. For another, Trump's oft-stated desire to wield the dollar as a cudgel against China and, by extension, Japan. He wants a stronger yen.
The real risk to the dollar, though, is Trump's fiscal irresponsibility. The $1.5 trillion tax cut his Republican Party passed last December -- and another $1 trillion of spending on tap for fiscal 2019 -- assumes Asia will continue gorging on U.S. Treasuries. How safe is that assumption when Washington's balance sheet is getting stretched?
Finally, there is the market's fourth driver, optimism on trade.
Hopes that Abe can shield Japan from the worst of Trump's trade wrath are not totally irrational. Trump's renegotiation of the U.S-South Korean free-trade deal ended well enough for president Moon Jae-in's economy. All Seoul did, really, was play along. It is allowing more U.S. cars into a market that, given quality considerations, probably will not buy many Ford or General Motors vehicles anyway.
The radical "historic" revision of the North American Free Trade Agreement that Trump proposed has fallen equally short of what was originally threatened. NAFTA 2.0 is a series of tweaks that, overall, change little. Trump, though, can claim this rebranding exercise as proof his "Art of the Deal" is making America great again.
This pattern could be Japan's friend. Tokyo is about to find if 686 days of Abe enabling Trump's bluster was worth it. Abe could always follow Moon's lead and promise to help Detroit ship more cars to Japan -- knowing full well Toyota, Nissan and Honda have little to fear.
There is just one problem: fallout from China. A bilateral deal with Trump would, at best, be a wash for Japan export-wise. But without an accord, the potential loss of Asia's main growth engine is a clear and present danger to Abenomics. The uncertainty may have Japan Inc. scaling back on whatever modest wage increases CEOs might have been earmarking for 2019.
In lieu of bold upgrades, Abenomics bet heavily on a virtuous cycle: larding up Japan Inc. with profits that executives would share with households. But the real economic benefits are hard to see. Instead, we have a surge in the Nikkei that may be based on unreal irrational exuberance.
Remember the Templeton sequence. This rally was born on pessimism that Japan's previous government could defeat deflation and cap the yen. Skepticism abounded as Abe slow-walked reforms. Optimism then soared as economic growth returned. Now euphoria reigns as Trump's own stock boom sends waves of capital Tokyo's way.
Whether this boom will end in tears is anyone's guess. The Nikkei's rise would seem more rational, though, if the underlying economy were where Abe promised it would be after nearly six years of Abenomics.
William Pesek is an award-winning Tokyo-based journalist and author of "Japanization: What the World Can Learn from Japan's Lost Decades." He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia, for his work for the Nikkei Asian Review.