The current trailing P/E ratio of the Japanese stock market is 18.09 and the forward P/E ratio is 14.31 (July 1^st, 2023, calculated using the Nikkei 225 index companies).  Does this mean that the Japanese stock market is undervalued or overvalued?

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Japan Stock Market (Nikkei 225 Index): P/E (TTM), EPS (TTM) & CAPE Ratio

* EPS (earnings per share) in the table above has been indexed to start from the base value of “100”.

To answer this question, let’s briefly discuss the key factors that have been used to explain the current interest towards the Japanese stock market and why Japan has once again become an interesting market for foreign investors:

1. Attractive Valuations: When measured using all traditional valuation metrics, the Japanese stock market is trading at lower multiples relative to historical averages. However, the multiples have already increased a lot as the Japan stock market has boomed during the first half of the year 2023. The valuations are still much lower when Japanese companies are compared to e.g., U.S. stocks, but you have to remember that the technology sector plays a much smaller part for the Japan stock market than it does for the U.S.
2. Corporate Governance Improvements: Historically, corporate governance practices in Japan have favored close ties between companies, banks, and government agencies. Japanese companies have traditionally held cross-shareholdings in each other, often creating complex ownership structures. While this practice was meant to foster long-term relationships, it has sometimes been criticized for hindering transparency and efficient capital allocation. However, in recent years, efforts have been made to improve corporate governance and enhance shareholder rights to align with international standards. This includes initiatives to increase board transparency, strengthen independent directorship, and promote shareholder engagement.
3. Dividend Growth: Japanese companies have been increasing their dividend payouts to shareholders in recent years, which can be attractive to income-seeking investors. This is part of the broader push for improved shareholder returns.
4. Currency Considerations: Fluctuations in the Japanese yen can create opportunities for investors seeking exposure to currency movements. A weaker yen can boost the profitability of Japanese exporters, which can positively impact stock prices.
5. Diversification Benefits: Including Japanese equities in a global investment portfolio can provide diversification benefits, helping to reduce overall portfolio risk by spreading exposure across different geographic regions.

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Let’s discuss more about the first point, attractive valuations.

Comparing the current valuation to history is difficult due to the unique history of the Japanese stock market. Let’s take a brief history lesson of the country’s economic history:

1. Economic Boom (1970s-1980s): The 1970s and 1980s were marked by Japan’s economic boom, with the Japanese stock market reaching record highs. The period saw the rise of large conglomerates, known as keiretsu, which contributed to the market’s expansion.
2. Bubble Economy (Late 1980s): The late 1980s saw an unprecedented asset price bubble in Japan, driven by speculative investing and soaring real estate prices. The Nikkei 225 index reached its all-time high in December 1989, but the bubble burst shortly thereafter. However, it’s important to remember that there was never a huge sudden drop in the asset prices. The market just kept moving steadily lower and lower. It can be argued that maybe the Lost Decade could have been avoided if there had been a violent decline in asset prices forcing the country the country to take forceful actions to reform the economy.
3. Lost Decade (1990s): The slow bursting of the asset bubble led to a prolonged period of economic stagnation and deflation in Japan. The 1990s were characterized by sluggish growth, financial instability, and a declining stock market. The interest of the foreign investors remained non-existent.
4. Market Reforms and Recovery (2000s-2010s): In the early 2000s, Japan implemented financial and corporate governance reforms to address some of the issues that had contributed to the previous decade’s challenges. The market gradually began to recover, although volatility remained. The 2008 global financial crisis also impacted the Japanese stock market, leading to a sharp decline.
5. Abenomics (2012-2020s): In 2012, Prime Minister Shinzo Abe introduced a set of economic policies known as “Abenomics,” which aimed to stimulate growth through monetary easing, fiscal stimulus, and structural reforms. The policies had mixed results, and the market experienced periods of gains and losses.
6. COVID-19 Pandemic (2020s): The COVID-19 pandemic had a significant impact on global markets, including the Japanese stock market. Central bank interventions and fiscal measures were implemented to mitigate the economic effects of the pandemic.

It’s still unclear what will be the next chapter of the Japanese economy and stock market. It all depends how the country manages to deal with these key considerations:

1. Aging Population and Demographics: Japan’s aging population has been a widely discussed topic since the 1980s. However, the country has managed to deal with its demographic issues surprisingly well so far. Still, the truth is that Japan in the 2040s will be a widely different place that it is currently.
2. Export-Oriented Economy: Japan is known for its export-oriented economy, and many of its large corporations have significant exposure to global markets. This can make the Japanese stock market sensitive to changes in international trade dynamics and currency fluctuations.
3. Government Policies and Interventions: The Japanese government has sometimes intervened in the stock market to stabilize or influence its performance. Examples include actions taken during times of economic stress or efforts to manage currency exchange rates.
4. Inflationary versus Deflationary Pressures: It will be seen if Japan will be able to produce inflation in the long-term or will the country continue to struggle with deflationary pressures.
5. Cultural and Language Factors: Japan’s unique culture, business practices, and language can create challenges and opportunities for international investors navigating the market.