Japan's Markets Haven't Stopped Shaking

Aftershocks from the earthquake that hit Japan on Jan. 17 are still rumbling through Tokyo's stock market. Uncertainty about the size of the repair bill, how it will be paid, and what companies will benefit has confused investors and sent the Nikkei stock index on a wild roller-coaster ride. After plunging to 17,785, the index climbed, then dipped, and by mid-February was hovering at 17,991 (chart).

Don't expect much improvement. Indeed, a consensus is forming that the Tokyo market is heading downward--at least over the short term. The aftermath of the quake could force interest rates up and divert powerful savings pools controlled by the Japanese government away from the market and into the reconstruction effort. On top of that, no one seems to know what the true earnings picture is for many Japanese companies, since the earthquake has disrupted sales for some while fattening order books for others. Says Jason James, strategist at James Capel Pacific Ltd. in Tokyo: "The quake was a clear negative for the market."

To be sure, almost no one foresees a major crash. That's because the Japanese government would likely intervene with the "price-keeping operation" it has used in the past when shares sink so low that banks' equity portfolios can no longer cover bad-loan write-offs. A PKO means injecting public funds into the market and jawboning private institutions into helping out.

But because of the quake, the government may have less money at its disposal to buy shares this year. In recent years, the government has customarily orchestrated an upturn in the Nikkei in February and March, after companies and banks sell off shares to bolster their balance sheets before the fiscal year ends. Now, some analysts fear that rebound may not happen--or prove much weaker--because of strained government finances. In addition, Alexander Kinmont, vice-president of Morgan Stanley Japan Ltd., worries that the government may channel money from the postal savings and life insurance systems, which it normally uses for PKOs, into loans for rebuilding.

The short-term economic pressures on the market are formidable. For starters, reduced consumer spending may slow Japan's recovery as frightened Japanese squirrel away more money for the next big temblor. Department stores and other retailers report a recent fall-off in traffic.

More important, perhaps, interest rates seem poised to move higher, as the government starts issuing possibly $70 billion or more worth of new bonds to pay for quake rehabilitation. Analysts see yields on benchmark 10-year government bonds going to 5.4% from a current 4.6%. Money invested in these more attractive bonds could divert funds from the stock market.

Individuals and companies needing to rebuild assets lost in the quake may have to sell shares to raise cash. That could help send the market down to 17,000 or as low as 16,000, says James Capel's James. That's when the government would probably initiate a PKO.

BIG GAINS? As the cleanup continues, investors' eyes will turn to earnings. James Capel believes quake-related expenses will pare corporate earnings growth to 8% from a previously forecast 20% for the fiscal year ending in March, although the firm projects 35% earnings growth for the next fiscal year. Still, the Nikkei is selling at a mind-numbing price-earnings ratio of 74.

But the true earnings picture could be clouded if companies use the quake as a pretext to charge off other items. That could further confuse investors. The market has already discounted any quake-related gains for construction companies, whose share prices rose just after the temblor, then dipped sharply. Shares of electronics companies and department stores have also dropped.

Despite all the short-term bears in Tokyo, there are enough bulls who say it doesn't pay to worry too much about Japan's market for the long haul. Even with new pressure on interest rates and government savings pools, the Nikkei could return to 22,000 by yearend, they argue. John F. Bahrenburg, senior strategist at Merrill Lynch Japan Inc., predicts equity prices will surge 40% to 50% over the next five years.

Perhaps. In the meantime, and especially this spring, investors should be braced for rougher times.

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