Japanese stocks hit record highs for days on end…foreign investment floods in on governance reforms and fundamentals

"Attractive low PER despite political instability"

U.S. market corrections or a sharp yen rise are downside risks

The Japanese stock market has been hitting consecutive record highs, driven by corporate governance reforms and a steady inflow of foreign investors. Analysts say that despite political instability in Japan and the risk of a U.S. market downturn, such shocks are more likely to present buying opportunities than to end the rally.

On the 24th (local time), according to CNBC, the Nikkei 225 rose 0.3% to 45,630.31, setting another record high. The broader TOPIX index, which includes small- and mid-cap companies, also rose 0.23% to 3,170.45.

After the Bank of Japan’s surprise decision last Friday to sell a large portion of its ETF holdings, the Nikkei 225 and TOPIX fell but quickly rebounded.

The Japanese market’s upswing accelerated over the summer. The U.S.-Japan trade agreement concluded in July and finalized in September helped restore investor confidence in exporters that had been held back by tariff concerns. Shares of automakers, semiconductor companies and AI-related firms rose.

Kei Okamura, Japan equity portfolio manager at Neuberger Berman, said, "The year began with a broad rally, which over the past two to three months has expanded into mid- and small-cap value stocks, and more recently into tech stocks."

He said Japan is finally "emerging from the 30 years of deflation it lost," noting that real wages and household consumption, while modest, have shown signs of recovery and inflation has stabilized around the Bank of Japan’s 2% target. The yen briefly plunged to 160 yen per dollar last year but has since stabilized.

He noted that if domestic consumption rises, companies dependent on the Japanese domestic market would benefit, many of which are small- and mid-cap firms that make up the TOPIX.

Another key factor is relative value.

Zuhair Khan, senior fund manager at UBP Investment, said the main drivers of the rise in Japanese stocks are fundamentals and cheaper valuations compared with other developed markets.

According to FactSet, the price-to-earnings ratios (PER) of the Nikkei 225 and TOPIX are 23.01 and 17.46, respectively. Considering the S&P 500’s 28.54, they are much cheaper. The PER measures a stock’s price relative to net earnings; the higher the PER, the more investors are paying for a stock relative to earnings.

Activist campaigns in 2023 and 2024 forced cash-rich companies and firms reliant on real estate to use capital more efficiently. U.K. activist fund Paliser Capital has taken a large stake in Japanese real estate developer Tokyo Tatemono, claiming it was "trading at a 45% discount to net asset value."

Khan noted that recently there has been investment by new activist investors targeting large companies with loss-making or low-margin business segments. About two-thirds of TOPIX 100 firms operate such businesses, so there is significant room for improvement.

Political instability in Japan has not halted the stock market rally. Okamura said, "Most of the factors supporting the current Japanese equity market are largely unrelated to politics."

He said that whether former Minister of Economic Security Sanae Takaichi or Minister of Agriculture, Forestry and Fisheries Shinjiro Koizumi wins within the ruling LDP, corporate governance and capital market reforms will proceed.

Okamura warned that the Nikkei, which is composed mostly of large companies, looks expensive at nearly 20 times expected earnings. However, TOPIX is trading in the mid-teens and remains undervalued by investors, he said. He dismissed concerns that stock prices had become unsustainably high. He expects sector rotation from stocks that have risen due to restructuring to those whose share prices have lagged to drive the next phase of the rally.

Lombard Odier also offered an optimistic outlook. In a recent report it said, "Given a solid macroeconomic backdrop, positive corporate reforms and performance, and the return of foreign investors, there is a high probability of further gains in Japanese equities."

Strategists expect Japan’s GDP growth to be about 1% in 2025 and 2026, and that growth and rising prices will contribute to corporate earnings growth. While there are risk factors such as political instability after Prime Minister Shigeru Ishiba’s resignation, entrenched inflation, and the Bank of Japan’s risk of policy missteps on rates, concerns about Japan’s fiscal situation are overblown, they argued. Backed by a current account surplus and high domestic savings, the government’s debt burden is manageable.

The Tokyo Stock Exchange has been urging companies to use capital more efficiently, unwind cross-shareholdings, and increase the number of tradable shares. Okamura added that market liquidity has increased as founding families sell stakes due to inheritance tax rules.

Nevertheless, global risks remain significant. Khan and Okamura warned that a U.S. market correction or a yen surge similar to August 2024 could trigger stock declines. However, they interpreted such events as buying opportunities rather than a long-term deviation from the trend.

Guest reporter Jung-ah Kim kja@hankyung.com