Aug. 1 (Bloomberg) -- The defeat of Japan's ruling party in upper house elections gave investors another reason to shun the world's second-biggest stock market.

The Nikkei 225 Stock Average, the worst performer among the world's 20 biggest equity benchmarks, has little chance of catching up with international indexes after the Liberal Democratic Party lost control for the first time in 52 years, said Joseph Quinlan, chief market strategist at Bank of America Corp. Prime Minister Shinzo Abe's plan to deregulate state- controlled industries and cut the government's $6.8 trillion debt may be hindered by the July 29 vote, he said.

Abe has ``only been modestly successful in getting his policies implemented,'' said Donald Gimbel, who manages $1.8 billion at New York-based Carret & Co. ``With the change in control in the upper house, you're slowing down this process even more.'' Gimbel is ``underweight'' Japanese equities and said the election will ``inhibit'' him from boosting holdings in the world's No. 2 economy.

The divided government may weaken Abe's grip on power, as in the 1990s, when seven prime ministers failed to rescue the economy from deflation and recession, while the Nikkei lost 51 percent of its value. The index has lost 2.1 percent this year.

Even after they doubled since hitting a more than two- decade low in March 2003, Japanese stocks are cheaper than shares in the U.S. and Europe when measured by book value, or assets minus liabilities, according to data compiled by Bloomberg. Japan is the world's second-largest equity market after the U.S. with a value of $4.89 trillion.

Cheaper Shares

Shares of companies in the Nikkei trade at an average of 2.05 times book value, compared with 2.82 times for the Standard & Poor's 500 Index and 2.4 times for shares in the Dow Jones Stoxx 600 Index of European companies. Investors look at the measure because many Japanese companies own real estate that isn't reflected in their earnings.

Since the election, the Nikkei has fallen 2.4 percent while the S&P 500, the benchmark for American equity, has dropped 0.3 percent.

Investors already have reasons to be concerned about the pace of reforms in Japan, where public-works spending in the 1990s failed to prevent three recessions and a collapse of land prices that forced the government to spend 12.4 trillion yen ($104 billion) bailing out the nation's banks.

Calls to Resign

Companies stepped up purchases of stakes in each other for the first time in at least 16 years in the 12 months ended in March, a strategy used to support share prices and prevent unwanted acquisitions in the 1990s, according to Tokyo-based Nomura Holdings Inc., the nation's largest brokerage. Investors also grew concerned in July after a Tokyo court ruled in favor of condiments maker Bull-Dog Sauce Co.'s decision to dilute a stake held by activist shareholder Warren Lichtenstein's takeover fund.

The 52-year-old Abe, who has been in office 10 months, has resisted calls to resign since the July 29 election displaced the LDP as the biggest party in the upper house of parliament for the first time since 1955. Agriculture and fisheries minister Norihiko Akagi resigned today, the first cabinet casualty of the electoral rout and the fourth minister Abe has had to replace.

Public anger over missing pension records that may result in millions of dollars in unpaid benefits and scandals that led to the suicide of one minister and the resignations of two others, dragged Abe's approval rating to a record low before the election.

Divided Government

Abe also lost popularity because he has refused to rule out raising the 5 percent sales tax. Former Finance Minister Sadakazu Tanigaki last month said the tax was necessary for the government to achieve its goal of balancing the budget by 2011. His successor, Finance Minister Koji Omi, called yesterday for the debate to start this fall amid opposition from the Democratic Party of Japan, which captured the most seats in the election.

``Under Abe, you now have a divided government, a lot of resistance to any kind of reforms he's going to propose or the threat of continued muddle,'' said Quinlan, who works at Bank of America's offices in New York. The Charlotte, North Carolina- based company's investment management unit oversees $566 billion. ``Another big move up in Japan will require the political fog to clear and it's too early to say whether it will.''

Investors say profits at Japanese companies show that the nation's longest post-war expansion is safe.

``I'm focused on earnings more at this moment and I think Japanese companies are reporting nice numbers,'' said Taizo Ishida, who helps manage $700 million in Japanese stocks for Matthews International Capital Management LLC in San Francisco.

JFE Earnings

JFE Holdings Inc., the world's third-biggest steelmaker, said July 30 that first-quarter profit gained 63 percent and Mitsubishi Electric Corp., which makes robots and mobile phones, reported an 87 percent jump in net income for the period.

JFE Holdings shares rose 5 percent and Mitsubishi Electric climbed 9.9 percent on July 30, helping lift the Nikkei 0.03 percent after falling more than 1 percent earlier in the day. The Nikkei fell 40.41, or 0.2 percent, to 17,248.89 yesterday.

``The worse-than-expected defeat has prolonged political uncertainty and is clearly negative for the stock market,'' Nishizaki, a strategist in Tokyo for London-based HSBC Holdings Plc, wrote in a note to clients after the election. Abe's decision to stay in office ``is even more negative for the stock market than the election results, as it will probably increase criticism from the opposition parties and resistance within the LDP.''

To contact the reporters on this story: Patrick Rial in Tokyo at prial@bloomberg.net; Michael Tsang in New York at mtsang1@bloomberg.net.

Last Updated: August 1, 2007 03:57 EDT