What does Japan's weak economy conceal?

The Nikkei 225 index is Japan's oldest stock index, recently breaking the 40000 point mark. This is a significant milestone as it took 34 years to break through 39000 points, the previous high set in December 1989. This makes it one of the longest lasting bear markets among all major stock indices in post World War II history.

Firstly, Japan in the 1980s was like a wild rabbit. In the 1980s, the Japanese stock market experienced a rapid acceleration of the starting line. The Nikkei Index rose from 9000 points in early 1984 to 39000 points at the end of 1989 in just 5 years. From an economic perspective, Japan is a major supplier of automobiles, consumer electronics, semiconductors, and industrial machinery, and it is still growing. In sharp contrast to the past 15 years, the returns of American investors have been particularly strong, as the exchange rate of the Japanese yen against the US dollar has also risen by 75% during the same period. The rise in stock prices far exceeds the improvement in fundamentals. The decrease in interest rates has further fueled the speculation in real estate prices and stocks, providing liquidity. Ultimately, Japan's economic competitive advantage proved unsustainable as other Asian economies quickly created clones of Japanese companies. These continuously declining fundamentals ultimately led to the collapse of the Japanese stock market and economy, leaving this already poorly populated country burdened with huge debts. As a result, Japan fell into a twenty year lackluster performance.

Secondly, since 2009, the Japanese economy has become increasingly like a turtle. Since 2009, considering the weakness of the Japanese yen, the returns brought by Japanese stocks to American investors have been more like the proverbial "turtle", growing only 6.2% annually. Therefore, since 2009, although the rise of the Japanese stock market has been impressive in Japanese yen terms, it has been slower and less sensational in US dollars.

The dividend yield of the Japanese stock market is often much lower, which is one of the reasons for the significant difference in overall return performance between the MSCI Japan Index and the Dow Jones Index. On May 23, 2024, the Japanese stock market rose by 333% at local prices, but due to the weakness of the yen, the final return for American investors was only 151%. Japan and all other major indices in the world are overshadowed by the profit growth of US technology leaders, who dominate the NASDAQ 100 index and have higher multiples of their profits. A more common index used for large cap stocks in the United States is the S&P 500 index, which has a much greater weight on these high growth themes than the MSCI Japan index or the Dow Jones index.

In addition, Japan is facing a problem of sustained deflation, which has led to an abnormally high debt to GDP ratio, currently exceeding 200%. This combination has kept Japan's long-term interest rates at 0% level. Since 2012, Japan has adopted an enhanced corporate profit model. The impact of these competing narratives is that Japanese companies have doubled their profit margins from 3% to 7%, but their P/E multiples have stagnated. This forms another contrast with the US market, where valuation multiples have expanded during this period.

Overall, we are optimistic about Japan's performance in the international market. When considering the level of investment in Japan in a balanced investment portfolio, Japan provides convincing reasons as the preferred investment in developed markets. The long-term valuation framework has long shown that international market valuations are attractive, and the depreciation of the yen further strengthens Japan's valuation. Although the United States has seen a higher economic and earnings growth rate on a forward-looking basis, the Japanese stock market has proven to be an unknown hero, quietly setting records for profit and earnings growth while maintaining a lower P/E ratio due to macroeconomic challenges. Although Japan continues to face population and debt challenges, its strong and stable growth in returns makes it attractive in balancing its international assets in investment portfolios.