Japan’s Market Boom Is Just Getting Started. 2 Big Reasons Why.

About the author: Patrick L. Springer is an institutional-equities business developer and Japan and Asia market specialist. He worked at Morgan Stanley in management roles for more than 20 years.

Japan just concluded a 34-year trek in the wilderness of deflation and ended its nearly 20-year negative interest-rate policy. The stock market has responded by achieving new all-time highs, last seen in 1989, rising 35% in the past year.

This might look like the top, but a closer look at Japan’s market suggests that the end is just the beginning for the world’s third-largest market. This year likely marks the beginning of a multiyear Japan market revival that will start a major new capital markets cycle. Japan’s companies are just beginning to celebrate a long-awaited return of pricing power supported by an enamoured global investor base looking for international ideas in a friendly market.

Investors should focus on two trends. First, new micro and macro forces are at work to make Japan a preferred non-U.S. destination for several years. With the U.S. dollar at 20-year highs, portfolio managers know that it is typically time to diversify and buy cheaper overseas markets, but where to go? Europe is cheap but challenging, and the I of India is what currently remains best of the emerging markets BRICS grouping. Exposure to Asia is important for global portfolios given it is 45% of global gross domestic product. Yet strategists say that we now live in a “multipolar world,” a euphemism for the highest level of geopolitical risks in the world in decades. This limits China investment allocations for now.

But Japan is a pre-eminent security partner for the U.S. Japan also is quickly becoming a key partner in U.S. reshoring strategies, especially as an alternative supplier of semiconductors and technology components. The reshoring trend is compounded by the yen’s weakness. At nearly 152 yen to the dollar, Japan’s currency is trading at the lowest ratio since 1990. That means Japan is also likely to regain market share that it lost over the past 20 years to China in automobile components, industrial products, and machinery. Status as a security partner matters to investors now, which will keep allocations to Japan higher for longer.

Second, Japan’s differentiated market structure may provide more alpha-idea opportunities than investors might expect from an older, developed economy. In the U.S., megacaps and the Magnificent Seven rule the world for investors—and for good reason, given their recent outperformance. The high level of exchange-traded fund penetration in the U.S. also favors large-caps over small- and medium-capitalisation stocks. But in Japan, the list of Japan’s largest companies remains unchanged: Excluding SoftBank, all were established pre-1960.

According to Abrdn Investments, 45% of Japan’s benchmark Topix Index of 2000 constituents have no analyst research coverage, compared with just 3% of the Russell 3000 universe for the U.S. As inflation sparks growth, earnings surprises and inflections of Japan’s under researched companies will lead to significantly higher alpha capture opportunities.

Additionally, the Japanese government and the Tokyo Stock Exchange have initiated important corporate-governance reforms, and 26% of all listed companies have submitted specific plans to improve their stock valuation. But many more companies have yet to respond, providing more opportunities for investors.

Sorting Japan’s nearly 3,900 stocks into market segments is revealing. Japanese mid-cap and small-cap stocks have lagged behind large-cap stocks by 40% and 60% year to date, respectively, and have lagged by 25% and 46% on a one-year basis.

Such underperformance by itself is one thing, but for the many investors who have never seen inflation, wage growth, and domestic sales gains in Japan, they may find a discovery universe of new stocks with interesting characteristics such as these:

Organo , a $2 billion market-cap water treatment company that has traded over $60 million a day on some days and counts Taiwan Semiconductor Manufacturing as one of its key growth customers.

Nakanishi , a $1.5 billion dental-equipment and precision-tools maker that grew sales 23% last year, sports a 2.5% yield and a 24% return on equity, and has 12% of its stock price in net cash.

Chugoku Marine Paints , a global top-three maker of marine paints that has a 20% global share and a 15% return on investment capital, sells at nearly 11 times earnings, and has a 2.6% dividend yield.

Overall, this analysis finds nearly 100 companies with a market cap above $1 billion with net cash equal to 20% or more of their stock price.

The bottom line is that Japan’s culture of innovation, combined with an end to deflation, is likely to produce a new wave of capitalisations. During the decades of deflation, corporates and consumers alike were incentivised to save more, spend less, and underinvest. But with nominal GDP growth now running at a whopping 5% and record wage growth, inflation incentivises new capital investment, stimulating a new investment-banking cycle of financing.

There are risks to this outlook. Double-digit market rallies can lead to pullbacks, and investors need to watch for threats to Japan’s inflation and currency levels and to its appetite for reform. But what’s most important for investors to realise about Japan is how much has changed there, amid a changing world.

Guest commentaries like this one are written by authors outside the Barron’s newsroom. They reflect the perspective and opinions of the authors.

Wall Street’s hottest trade has gone ice cold.

For years, it paid off to buy stocks that were rising in price—and bet against struggling shares. The momentum trade was especially profitable this year, as investors piled into hot stocks including Micron Technology, Nvidia, Advanced Micro Devices and other artificial-intelligence darlings while wagering against those likely to be hurt by the embrace of AI.

The S&P 500 Momentum Index soared 44% in the second quarter, its best quarterly performance on record, and it surged 133% over the past five years, nearly double the broad market’s performance.

Mega funds and rookie investors alike piled into the trade, some using leverage and options contracts in an effort to amplify their returns, propelling the underlying shares higher.

“It is a self-fulfilling prophecy,” said Matthew Tym, managing director at Cantor Fitzgerald, of the trade.

Suddenly, the trade is a loser. The momentum index has tumbled more than 9% since July 1, lagging behind the S&P 500’s 2.8% gain. The index—which tracks stocks in the S&P 500 based on a “momentum score”—is on track for the biggest quarterly underperformance in 25 years. July was the second-worst month for the momentum trade in around 40 years, according to Bank of America estimates; the only month worse was April 2009, in the teeth of the global financial crisis.

Hedge funds that bought momentum shares while shorting low-momentum stocks suffered even more. At the same time, a basket of the most popular stocks held by hedge funds tracked by Goldman Sachs recorded its biggest one-month underperformance in July relative to the S&P 500 in more than 20 years, according to the bank’s analysts.

Momentum trading is based on a rather simple observation: Investments that go up tend to keep outperforming; those that underperform often remain laggards. This kind of trading might seem too simple a stock-picking strategy to work. Yet it often has.

“For decades, it didn’t take a lot of sophistication to run a momentum strategy and make a decent living at it,” says Agustin Lebron, senior researcher at EquiLibre, a trading firm.

Part of the reason: It takes a while for corporate and other information to spread to various investors, so they slowly build positions, producing buying momentum.

“A huge pension fund can’t flip around its positions in a day,” says Lebron. “Behavioral biases also account for some of the effect, as well—people tend to sell their winners too early and hold losers too long.”

Fans of the strategy point to the human tendency to extrapolate from past results—and chase investment returns—noting that momentum patterns have been evident in markets for decades, even centuries. They also say that some of the worst months for momentum strategies are during longer periods of outperformance.

Some have been doing the trade by buying the strongest investments in a sector while shorting the weakest; others lean in to rising markets or asset classes. Still others use a quantitative approach or turn to banks or others who sell ways to make distinct wagers on momentum as a “tradable factor” or a “thematic basket.”

The fans remain believers. “Any strategy has disappointing periods,” says Antti Ilmanen, global co-head of the portfolio solutions group at AQR Capital Management.

The surge in Moderna and other biotech stocks helped crush the momentum trade. These shares were among the most heavily shorted in recent years, but positive news on a cancer vaccine from Moderna and Merck sent those stocks flying, crushing some quant and other hedge funds. Moderna is up around 150% so far this month.

These traders had an especially rough day on Aug. 19, which Goldman Sachs told its clients was the worst day for “systematic long-short managers” in more than two years. About half of the losses were because of momentum trades, the bank said.

Some traders have begun to short, or bet against, the very stocks that propelled the momentum trade earlier this year. Net short positions in futures tied to the Nasdaq-100 index among speculators recently climbed to some of the highest levels of the past two decades, according to data from the Commodity Futures Trading Commission.

The about-face is a sign of how markets have become more treacherous for investors, even as indexes keep climbing. Part of the issue: the recent meltdown of Situational Awareness, a hedge fund that had piled into some of the most popular momentum shares, including chip stocks. After a period of market tumult, Nvidia shares rocketed almost 9% after its earnings, showing how quickly sentiment can shift.

Some investors say the run-up in share prices driving tech stocks higher reminds them at times of the dot-com frenzy decades ago.

Mike Ogborne, the founder of San Francisco-based Ogborne Capital Management, said he has grown more cautious on technology stocks and is keeping more of his portfolio in cash than he typically does.

And he is nervous about the surge in spending by technology giants and quarterly capital expenditures that keep rising.

“It is a little bit like Cinderella and the clock striking midnight. You don’t know when midnight is going to come around,” Ogborne said. “They don’t send a memo around telling you when the capex cycle is over.”

Japan’s Market Boom Is Just Getting Started. 2 Big Reasons Why.

Wall Street’s hottest momentum trade has reversed sharply, as former winners tumble and heavily shorted stocks surge.