A Sucker's Rally on the Nikkei?

Japanese stocks have risen sharply since April, but the fundamentals remain, well, lousy

The scent of quick money is back in Tokyo. After sliding to 20-year lows in late April, Japan's benchmark Nikkei index has stormed back, up some 18.6% since then. On June 17, the index cleared the 9000 mark, a key psychological milestone and the highest close in more than six months. Nearly 225 stocks -- or 15% of the total -- on the TOPIX, or first tier of the Tokyo Stock Exchange, are at 52-week highs.

All of which is something of a mystery to many analysts and traders in Tokyo. Japanese stocks are staging a rally in the face of zero economic growth, a very weak banking sector, and the corrosive impact of deflation. And it's hard to make the case that stock prices are foreshadowing a big economic turnaround. "Most economic indicators are trending downward," says Goldman, Sachs & Co. economist Kathy Matsui.

So who's buying? Big foreign-pension and mutual-fund managers. Foreigners represent 48% of the market's turnover and have bought some $16 billion in Japan since April.

The gaijin rationale: Japanese corporate chieftains have made their stocks more attractive with higher dividends and aggressive stock buyback programs. Buybacks jumped nearly twofold in the fiscal year that ended in March, to $23 billion. Nintendo, Nomura Holdings, and Toyota Motor were among the biggest. What's more, cost-cutting will help fuel an expected 8% rise in corporate profits for the fiscal year ending in March, 2004. The Japanese economy is in "macro-hell and micro-heaven," says Peter Cundill, who manages two Japan-only funds with $66 million in assets for London-based Peter Cundill & Associates Ltd. Investors are borrowing yen in Japan at near-zero rates, then investing it in companies that offer dividend yields at an attractive 2% to 3%, Cundill points out.

Sensing that the time is right, Japanese companies are raising money in the equity markets. NEC Corp.'s chipmaking unit plans a separate listing on the Tokyo Stock Exchange in July. And ink-jet printer maker Seiko Epson Corp. will list shares late in June in an initial public offering that is valued at $810 million. Indeed, after the total market value of Japanese IPOs slumped to $3.7 billion in 2002, the lowest level in five years, the outlook for IPOs is looking up. HSBC Securities Inc. is forecasting a 13.5% rise in initial offerings, to $4.2 billion, this year.

Even so, the bounce back in Japanese stocks is modest. The Nikkei was only up 5.9% for the year as of June 18, vs. 11.4% for the Dow Jones industrial average and 14.2% for Germany's DAX. Smaller equity markets in Asia have also outperformed Japan. So think twice before betting the kids' college money on a major bull market. That said, some strategists think the Nikkei could hit 10,000 by the end of the year.

But there are risks. For instance, Japan depends on a healthy American appetite for high-end goods such as DVD recorders and luxury cars, and a U.S. recovery is far from assured. Moreover, if the yen strengthens to 110 yen to the dollar from the current 117 yen, all bets are off as exporters run for cover. Another problem is that Japan's rickety banks represent a big portion of the Nikkei, and are unlikely to get out from under their heavy debt loads any time soon. Plus, it's easy to forget that for every supercompetitive player there are scores of lesser lights with bloated cost structures. That has to change before the Nikkei really takes flight. "It is still a thin crust of companies that have made improvements," says Jeffrey D. Young, an economist with Nikko Salomon Smith Barney in Tokyo. Optimists should remember that back in 1999, plenty of fund managers screamed, "Buy Japan." Three years later, the Nikkei is just rising off the lowest prices it has seen in two decades.

By Brian Bremner

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