The great sell-off and why the Japanese market trades like a penny stock

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On the first full day of trading after the great Tohoku quake of 2011, recalls a browbeaten fund manager, the office was shuddering with aftershocks. The world’s largest nuclear plant, in Fukushima, was in meltdown and an explosion had blown its roof off. There was talk of evacuating Tokyo.

Japanese stocks closed that day 6 per cent lower.

“But in August 2024,” he says, bemoaning the brain-bending crash on Monday that wiped hundreds of billions of dollars of value from the market, “all it takes is a soft US jobs report and a modest hike in the Bank of Japan’s overnight rate to send the Nikkei Average down 12 per cent in a day. The whole market is trading like a penny stock.”

Tuesday’s session, during which the Nikkei rebounded with an equally absurd 10 per cent surge, did little to dispel the sense of an emerging market unhinged from fundamentals and playable only by the most risk-addicted speculator. In the space of a week, the broad Topix Index lurched drunkenly from being one of the best performing major benchmarks of 2024 to one of the worst, and then back into narrowly positive territory.

Emphatically not the picture of sober but resurgent investability that Japan has strained to transmit both to global investors and to millions of sceptical domestic households. It has daubed ever thicker coats of paint over the signage, but many can still clearly see the lights that read “casino.”

So is there any way back now?

In the short term, the disarray has yet to be tidied up, and the process may not even start while a US recession and war in the Middle East loom as external threats. Wednesday produced a speech from the BoJ’s deputy governor, which was taken by markets as sounding a dovish tone just a week after the governor had signaled the opposite.

The volatile yen, having been subject to multiple government interventions to push it higher against the dollar since April had, by Monday, risen far and fast enough that the Japanese authorities might legitimately have stepped in to weaken it again. The deputy governor’s comments served to achieve that, but without fortifying any sense that the BoJ has taken serious charge of its messaging.

There are perhaps three different conclusions investors will draw about whether to press on with Japan.

The cautious one will be that this past week you have exposed the true face of an economy and a stock market that remains, in spite of some genuinely bright spots and well-conceived cosmetic efforts, quite ugly. Zombie companies were allowed to live too long. Improvements in governance, capital efficiency, diversity and professionalization of management have come too late and too sparsely. Capital has been miserably misallocated. The promised virtuous cycle of wage increases and sustained reflation has not properly emerged. Far too many companies should not be listed at all, and the whole show is underpinned by a shrinking, aging population.

The most optimistic take is that, by provoking exactly the conclusion above, the last week or two have usefully flushed out the skittish money that the Japanese market would always have done better without. Long-only funds that have wavered on Japan while the yen seemed irretrievably weak may now decide that is no longer the case. When bigger and more stable capital takes a look at the scene, it will come in precisely because there is so much still wrong — but in theory improvable — in the market.

Unlike the constituents of US and big European bourses, where capital inefficiency has largely been punished out of existence, Japan still has it in abundance. For investors with the time and inclination to work out which ones are on the brink of making the leap to capital efficiency, there is big opportunity. But that suggests, rightly, that buying the whole market will always be pretty risky. The all-time high achieved by the broad Topix this year was deceptive because of how unevenly individual shares moved within that. Caveat emptor: this place is for stockpickers only.

The third, and perhaps most intriguing, conclusion is that we are watching something sufficiently extraordinary to provoke a fear of missing out: the spasms and ructions implied by Japan’s “normalization” after decades of abnormality. Ultra-loose monetary policy, deflation, a taboo against bankruptcy and a reluctance to consolidate have all characterized Japan to the investment world. Normalization, in one form or another, is going to be extraordinarily painful and perhaps, while it is under way, will make Japan look a lot like an emerging market. Get used to it.

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