What Does Nikkei 225 Above Bubble Highs Mean for Japan? A Conversation Among Friends.

Amid Japan's stock market hitting historic highs, I have a casual conversation with my friends in government and finance to dissect its surge, eyeing what lies ahead in a shifting global economy.

Disclaimer: Please note that the events and conversations in this article are dramatized for the reader's enjoyment and to provide an engaging narrative.

In an era where Japan's Nikkei 225 shatters records, soaring past its infamous 1989 bubble peak to heights unseen in over 35 years, people everywhere are asking the same question: Is Japan heading into another economic bubble, or are we seeing a real financial comeback? This significant milestone has kicked off lively discussions and debates among financial enthusiasts and experts, making many of us, including myself, eager to explore what's really driving this exciting trend.

Given this backdrop, a casual chat among friends—one serving as an aide in the Japanese parliament, let’s call her Yuki, and another working at a major Japanese bank, let’s call him Axel—unfolded, touching upon this financial milestone and its implications:

Last week during a dinner at my place, casually snacking while scrolling through our smartphones, my friend Yuki couldn't help but illuminate the room with her excitement, "Did you see this? The Nikkei 225 just hit an all-time high. Wonder if it's going to climb even higher…" Her eyes sparkled with anticipation, reflecting the buzz surrounding Japan's financial markets.

My other friend Axel responded, "Maybe it's time to reassess the Japanese stock market, huh?"

Yuki continued, "Since the beginning of 2023, the Nikkei 225 has surged by about 50% in just over a year."

Curious, I asked, "What's behind this incredible rise?"

Reflecting, Axel outlined, "Looking back, a few key events stand out. In the spring of '23, the Tokyo Stock Exchange urged companies to focus on efficient capital use. Then in April, Warren Buffett visited Japan, announcing his intention to buy more Japanese stocks."

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"It's the kind of news that makes you hopeful about stock prices," I remarked.

"The expectations play a huge role in stock prices, especially among foreign investors, who account for 70% of trading in Japanese stocks," Alex added.

"Really? Foreign investors dominate the market that much?" I was genuinely surprised.

"Yes, and they tend to buy stocks even at high prices if they anticipate further rises. This spring, they were particularly active in buying Japanese stocks," Axel noted.

"However, stock prices plateaued before the summer," I recalled.

"The key lies in corporate earnings. Specifically, net income—the amount left after all expenses and taxes, which ultimately belongs to shareholders—is crucial. But, the profit outlook for many companies turned pessimistic," Axel explained.

"Why did that happen?" I inquired.

"With the US dramatically raising interest rates since '22, there were fears of a global economic slowdown. Japan's stock market is heavily influenced by manufacturing industries that earn through exports, so global economic trends significantly impact it," Axel elucidated.

"Exporting companies benefit from a weaker yen, right?" I observed.

"Exactly. Currency exchange rates, particularly the yen's depreciation, have a significant impact on performance. The exchange rate went from around 130 yen to the dollar at the beginning of '23 to about 150 yen by November, boosting stock prices. A weaker yen increases the yen value of profits earned in dollars for exporting companies. Announcements of record-high profit forecasts by companies like Toyota in their interim earnings reports, and an influx of tourists benefiting non-manufacturing sectors, came with the yen's depreciation," detailed Yuki.

"And what about this year?" I asked.

"The new small-amount investment tax exemption system (NISA) favors investment trusts operating with foreign stocks. Buying foreign stocks requires selling yen, contributing to its depreciation. Meanwhile, the U.S. stock market hitting new highs signals a booming economy. Japan's listed companies are expected to post record net profits for the third consecutive year by March 2024. Foreign investors continue to buy aggressively," Axel shared.

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"It's not surprising then that Japan's stock prices are at an all-time high. But the 'high' from before I was even born was during the bubble period," I mused.

"The peak during the bubble was 38,915 yen at the end of 1989. But today's numbers, even if similar on the surface are very different in reality. Just looking at common stock price metrics makes this clear," Axel pointed out.

"What metrics?" I asked.

"One common metric is the Price-to-Earnings Ratio (P/E Ratio), which shows how many times the stock price is of the per-share expected net income. A high stock price compared to expected profits means that everyone expects the company to earn more in the future. The higher the expectation of earnings growth, the higher the P/E ratio. If it's too high, it's seen as excessive optimism about the company's future, potentially indicating a bubble. The P/E ratio now is completely different from during the bubble period," Axel explained.

"How so?" I was intrigued.

"A 'reasonable' P/E ratio is said to be about 14 to 16 times based on past experience. But at the end of '89, it exceeded 60 times. When comparing 'reasonable' stock prices to actual prices, the actual prices were about four times higher than what would be considered 'reasonable.'"

"That's incredibly high!" I exclaimed.

"After the bubble burst, stock prices languished for a long time, not fitting within the P/E of 14 to 16 range until the early 2010s. Japanese companies, previously focused on sales, began emphasizing profit, leading to significant growth in net income," Alex reflected.

"So, stock prices over the past decade have been rising with a P/E ratio of about 14 to 16 times?" I sought confirmation.

"Stock prices have generally increased along with profit growth. However, between '21 and '22, the P/E ratio temporarily dropped, making stocks undervalued, and the rise from '23 corrected this. As of February 16th, the Nikkei 225's P/E ratio was slightly over 16 times. It's not considered cheap, but it's not excessively expensive either," Axel clarified.

"So, there's a balanced expectation for corporate profits," I concluded.

Yuki butted in, "It seems like there's an underlying hope that Japan is changing. A major shift is from deflation to structural inflation. There is a view in my circles that Japan might finally enter a stage of real price and wage growth. If we enter a state of moderate inflation, it becomes easier for companies to increase profits through price hikes. Additionally, there's a strong push from the government and the Tokyo Stock Exchange to change public companies' attitudes towards using shareholders' funds efficiently or risk getting delisted. Despite concerns like a global economic downturn, there's optimism that the positive changes in Japan's stock market will continue,"

"As for companies rewarding shareholders, the expected total dividend payout for listed companies by March 2024 is 16 trillion yen, a record high, matching US levels in terms of net income percentage. Another way to reward shareholders, through share buybacks, is also rapidly expanding," Axel added.

"With wages expected to outpace inflation later this year, boosting consumption, and if demand increases, companies previously hesitant about capital investments might become more active. This virtuous cycle is a major reason foreigners are actively buying Japanese stocks.”

As our conversation wound down, the sense of optimism was palpable, mixed with a cautious awareness of the past. The remarkable journey of Japan's Nikkei 225, from the shadows of the bubble period to setting new records, has indeed sparked a nationwide dialogue. Amidst the intricate web of global economics, currency fluctuations, and investor sentiments, the resurgence of Japan's stock market seems to stand on firmer ground this time around.

As we parted ways, the conversation lingered in my mind. Japan's financial markets are at a pivotal juncture, not merely reliving the exuberance of the past but moving forward with a cautious yet confident stride into the future. It's a narrative of resilience, adaptability, and, most importantly, hope, echoing through the halls of parliament, the strategic meetings of banks, and casual chats among friends. The Nikkei's rise is more than a number—it's a sign that Japan Inc might once again be back!