How High Can the Nikkei Average Climb? The Pitfall Hiding at the Top

By Jiro Kido - Investor

The Nikkei Stock Average has broken through the 70,000 yen mark. In the market you now hear bullish talk everywhere - "80,000 yen is just a waypoint," "a golden age for Japanese equities has begun." Yet I have no interest in the index level itself. What we really need to ask is: what is supporting this rally, and how long can that structure last?

Many market participants analyze the Nikkei through corporate earnings, P/E ratios and EPS. But those tools alone cannot explain Japanese stocks today. The single greatest force driving this market is the historically weak yen.

Japan Is on Sale

From the standpoint of an overseas investor, the logic is extremely simple. A weak yen means the entire Japanese stock market is being offered at a discount. The value of Japanese companies has not suddenly surged. The value of the yen has fallen, and as a result Japanese shares have become cheap when measured in dollars.

What is more, foreign investors can earn a double or even triple return. They buy Japanese stocks with cheap yen, they enjoy capital gains as prices rise, and if the yen eventually turns stronger they pick up a currency gain on top. Look around the world and you will not find many markets this attractive.

But what about Japanese people, who are paid in yen and live in yen? Food, energy, building materials, overseas travel - everything has become more expensive, and the cost of living climbs year after year. Judged by share prices alone, Japan looks like a booming economy, but the international purchasing power of the yen has fallen sharply. I have long called this the 40%-off yen, the great Japan clearance sale.

In other words, seen from abroad, Japan has become the most attractive bargain market it has ever been.

The Government Understands This Structure

The government, of course, understands the mechanism. It has promoted the new NISA as national policy and poured enormous subsidies into strategic sectors such as AI, semiconductors, defense and green transformation. A weak yen lifts the profits of exporters and boosts the earnings of the companies in the Nikkei Average. And rising share prices deliver to the public the simplest possible message: the economy is doing well.

I have argued for some time that there is a correlation between the Nikkei Average and the cabinet approval rating that cannot be ignored. When stock prices rise, expectations for the administration tend to rise with them. That is precisely why the Japanese government has tolerated a weak yen and rolled out policy after policy that pushes share prices higher.

But the Mechanism Cannot Run Forever

A weak yen lifts stock prices, but it also imports inflation, squeezes households and pushes up long-term interest rates. If the government keeps expanding fiscal spending, the JGB market will grow more wary about fiscal discipline; if the Bank of Japan raises rates, mortgages and corporate activity will face severe strain. Hike too quickly and the economy cools; hike too slowly and the yen keeps sliding. Neither the government nor the Bank of Japan has an easy road left in either direction.

The important point here is this: the ceiling for the Nikkei Average must not be thought about in terms of share prices.

I believe the limit of the Nikkei Average is the limit of the weak-yen policy itself.

As long as the yen stays weak, foreign investors are likely to keep buying Japanese equities. Corporate earnings will keep expanding in yen terms, and the Nikkei Average may well rise beyond what the market considers reasonable. Markets, after all, always run hotter than anyone imagines.

But the moment the weak yen reaches its limit and the government and the Bank of Japan turn to a genuine strong-yen policy, the market will begin to spin in reverse.

Once the cheap yen - the greatest attraction of all for foreign investors - is gone, the reason to keep holding Japanese stocks fades with it. The exporter profits inflated by the weak yen will shrink, and profit-taking will beget more profit-taking.

A Grand Insider Nation

I have described the Japanese market today as a grand insider nation. I do not mean anything illegal by that. I am pointing to a structure in which the government itself supplies the market with the material that drives share prices higher, and in which the greatest beneficiaries of that policy are overseas investors.

For that very reason, the top of this market cannot be measured with P/E ratios and EPS alone. As long as the policy continues, the market can climb further than anyone expects. But every policy has a lifespan.

What determines the ceiling for the Nikkei Average is neither corporate earnings nor valuation. It is the lifespan of the weak-yen policy itself.

Today's high share prices are less the result of a dramatically stronger Japanese economy than a form of apparent prosperity, produced by a steep fall in the value of the yen. And nothing is sweeter than forbidden fruit. But that fruit always carries an expiration date.

When that day comes, the market will learn for the first time that what it is facing is not the limit of stock prices, but the limit of a Japanese economy dependent on a weak yen.