Brutal selling escapes Japan’s $6 trillion stock market

(Bloomberg) — Japanese stocks lost $1.1 trillion in value as they started August with a record three-day loss. For bullish investors, it provides a new reason to buy what has been one of the hottest trades of 2024.

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The stocks that have been hit the hardest are the ones that have risen the most, pushing prices down to more attractive levels. The valuation upgrade campaign that boosted the international appeal of Japanese stocks continues apace, and some of the froth has been removed from the now $6.1 trillion market.

While the Bank of Japan’s sudden interest rate hike last month caught traders off guard, the central bank continued with comments that it would not tighten so quickly as to risk further market turmoil. That helps cushion the yen’s sudden gains, removing a key threat to the stock market’s rise.

In terms of key global catalysts, the latest US labor market data helped ease concerns that the Federal Reserve is easing fast enough to avert a potential recession. And the world’s big tech companies are pressing ahead with plans to spend billions on AI infrastructure.

“It’s not like we’ve had a major economic or financial crisis,” said Tetsuro Ii, chief executive of Commons Asset Management Inc., adding that it will likely take only two or three months for the market to fully recover. Investors now recognize that monetary policy in Japan and the US has “entered a new phase”, taking this as a cue to exit crowded positions.

The benchmark Topix is ​​down 12% since the end of June. Stocks that outperformed earlier in the year suffered more. An MSCI Inc. indicator. of the nation’s semiconductor-related stocks — whose AI-fueled growth has been a key driver of this year’s rally — fell 25 percent over the period. A measure of banks, which rose on anticipation of higher rates, fell 16 percent.

“I wouldn’t call it a bubble, but the market was just blown away,” said Toru Yamamoto, chief strategist at Daiwa Asset Management Co. “When you need to reduce risks, the most inflated positions will be cut.”

Japan had become one of the favorite markets for global traders this year amid expectations that inflation will rebound after more than two decades of stagnant prices and hopes that Japanese companies will return more cash to shareholders at the beck and call of the Tokyo Stock Exchange.

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The recent slide makes shares cheaper, making them even more attractive to overseas investors such as Warren Buffett, who has poured funds into Japanese trading houses.

The Topix now trades at 13 times estimated forward earnings, compared with 20 times for the S&P 500. Japan’s chip spread is down 21 times from 35 times earlier this year.

“People felt the market went up a little bit too much last month,” but with the selloff “it’s back to where it should be,” said Masayuki Murata, managing director of balanced portfolio investments at Sumitomo Life Insurance Co. At current valuations, “you could say we’re at a bargain hunting level.”

The derivatives market shows sentiment remains positive on Japan, with open interest in rising Nikkei calls rising faster than bear puts. As a result, the put/call ratio fell back to its lowest level in about six and a half years, suggesting that bets on a market rally are becoming popular.

There are still risks, particularly from a stronger yen as the BOJ tightens further while the Fed eases. The currency’s drop to multi-decade lows helped propel stocks higher as a cheaper yen is seen boosting profits for Japanese exporters overseas.

Geopolitical tensions between Washington and Beijing, which took the wind out of tech stocks last month, remain in play, especially with the U.S. election looming.

The Nikkei Volatility Index, Japan’s version of the “fear gauge,” ended Friday at 45. While that’s down from its 85-month intraday peak, it’s still well above its long-term average of around 22.

For Ben Bennett, head of investment strategy for Asia at Legal & General Investment Management Ltd., crowded positioning has become a reason to avoid Japanese stocks.

“The question is whether this stretched positioning has been significantly reduced,” he said. “I suspect it will take more than a few days of volatility for that position to return to neutral. In any case, I think investors who are bullish on Japanese stocks may even add positions given the recent weakness.”

Given the various pressures on a market at high levels, the latest turbulence came as no surprise to Arihiro Nagata, managing director at Sumitomo Mitsui Banking Corp.

“I think a correction was waiting to happen on any trigger,” he said. “It was hard to predict, but I think positioning has become easy and the market has become cheap.”

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