In the tumultuous world of global finance, few stories are as intriguing as the quiet comeback of Japanese stocks. After decades of being overshadowed by other markets, Japan is once again making waves, and it's time to consider whether it's the right moment to bet on this Asian giant.

A Historical Context

To understand the current resurgence, it's essential to look back. Japan's economy and stock market have been through significant phases, often referred to as the "Lost Decades" following the speculative bubble and market crash of the 1990s. However, since 2012, Abenomics – a set of economic policies initiated by former Prime Minister Shinzō Abe – has been a major catalyst for change. These policies focused on long-term structural reform, monetary easing, and fiscal stimulus, which helped transform Japan's economy and equity market.

The Role of Abenomics

Abenomics introduced aggressive monetary easing, which weakened the Japanese yen against the U.S. dollar, stabilizing exchange rates and making life easier for exporters. This, coupled with progressive deregulation and a boost in domestic consumption through inbound tourism, created a virtuous cycle. The policies also aimed to increase labor force participation, particularly among women, and introduced new visa regulations to allow more foreign workers into the country. These changes have been instrumental in Japan's quiet revolution, making its equity market more attractive to investors.

Recent Rally and Factors Driving It

In 2023, the Japanese stock market was one of the world's best performers, with the Nikkei 225 index rallying by about 35% over the last 52 weeks. This surge was largely driven by a record weakening of the Japanese yen, which dropped to a 33-year low against the U.S. dollar. Additionally, corporate governance reforms and improved company management played crucial roles. Companies like Toyota and Canon are aggressively innovating and reclaiming market share, while tech leaders such as Fanuc and Yaskawa Electric are making significant strides in robotics.

The Impact of a Stronger Yen

However, the recent strengthening of the yen could pose a challenge. If the U.S. Federal Reserve drops interest rates, the yen could strengthen further against the dollar, which could be a headwind for Japanese stocks. This is particularly significant because many Japanese companies are heavily reliant on exports, and a stronger yen makes their products more expensive abroad.

Corporate Governance Reforms

Corporate governance reforms have been another key driver of the rally. The Tokyo Stock Exchange's push for companies to devise new capital improvement plans has been well-received by investors. These reforms aim to unlock additional upside potential in companies' shares and have contributed to the relative attractiveness of the Japanese stock market. If Japanese households were to invest just an additional 1% of their assets into the stock market, it could unlock an additional $150 billion in fresh buying power.

Valuations and Market Sentiment

Despite the rally, the average price-to-earnings (P/E) ratio of Japanese stocks has risen to around 14, just shy of its previous peak. This lofty valuation could serve as a headwind, especially if global economic conditions deteriorate. However, many investors believe that Japanese stocks are still undervalued compared to their Western counterparts. The lack of big-name tech heavyweights in the Japanese market might throttle back its potential, but it also presents unique opportunities for investors looking for value.

International Interest and Technical Analysis

International investors, including the likes of Warren Buffett, are re-entering the Japanese market due to enhanced governance standards, cheap stocks relative to the U.S. market, and a depreciated yen. The iShares MSCI Japan ETF (EWJ) has gained nearly 18% year-to-date, outperforming the S&P 500 Index. Technically, the $64 level is a critical resistance point for EWJ; breaking and holding above this level would indicate that Japan's market resurgence has staying power.

The Tech Sector and Future Prospects

While Japan's stock market lacks the tech giants that dominate other indices, it has its own strengths. The semiconductor sector, for instance, is experiencing a huge surge in interest, with several large manufacturers increasing their presence in Japan. This is seen as a safer way to capitalize on China's growth amidst U.S.-China tensions. Companies like Fanuc and Yaskawa Electric are leaders in robotics, a field that is expected to grow significantly in the future.

Market Volatility and Global Context

The recent market volatility, including a sharp decline in the Nikkei 225 and other global indices, highlights the interconnectedness of global markets. Fears of a U.S. economic slowdown and the impact of high interest rates have led to significant declines. However, the Nikkei 225 has shown resilience, surging over 10% in a single day to claw back losses. This volatility underscores the need for cautious optimism when investing in Japanese stocks.

Personal Touches and Investor Insights

As someone who has followed the Japanese market closely, it's clear that there's more to this story than just numbers. The cultural and societal changes driven by Abenomics have created a more investor-friendly environment. For instance, the push for greater female labor participation and the introduction of new visa regulations for foreign workers are signs of a society adapting to new economic realities.

Conclusion

Investing in Japanese stocks is not without its risks, but the quiet revolution underway presents compelling opportunities. With improved corporate governance, a weaker yen (at least historically), and a strong semiconductor sector, Japan is making a case for itself as a fertile ground for stock pickers and active investment managers. While the market may face headwinds from a strengthening yen and global economic uncertainties, the long-term structural changes and innovative spirit of Japanese companies make it an attractive bet for those looking to diversify their portfolios.

In the end, it's not just about betting on Japan; it's about understanding the nuanced story behind its quiet comeback. As markets tend to ascend gradually but descend rapidly, the current momentum in Japanese stocks suggests that this could be a story worth watching closely. So, is it time to bet on Japan again? For those willing to look beyond the surface, the answer might just be yes.