Japanese Stocks Are Breaking Out. Own Them.

The Nikkei 225 hit three closing highs in just the past week. (KAZUHIRO NOGI/AFP via Getty Images)

Japan’s stock market has broken out to new highs. Now, investors have yet another way to diversify their portfolios.

The Nikkei 225, one of Japan’s major stock indexes, has closed at seven record highs this year—three coming in just the past week. The index is up 14% this year.

It has been a long time in the making, given that the index didn’t reclaim its 1990 high until last year. When it did, sellers promptly came in to knock it lower. This summer, it finally powered through to those new highs.

Breakouts often portend more gains. They indicate something has changed to bring in more buyers at price levels that sellers time and again knocked down.

As Evercore strategist Julian Emanuel puts it, the Nikkei’s gain is “suggesting a durable upswing.”

Japan’s economy is growing and will keep expanding if projections are right. Economists expect real gross domestic product to inch up just under 1% annually for the next two years, according to FactSet.

Not even the Trump tariffs have knocked those expectations off course. Japan’s economy is export-oriented, but only a sliver of its GDP—under 4%— is from exports to the U.S.

Plus, Japan has close to a perfect inflation rate. After years of essentially no inflation, the country’s consumer price index has climbed in the past two years and will keep growing, but slower—to just under a tolerable 2% over the next two years. That shows companies have raised prices, helping them boost revenue, and reflects generally stable consumer demand.

That’s why the Bank of Japan’s policy rate is 0.5%, and is forecast to rise to 1% next year. Rates are finally in positive territory—a healthy sign of a growing economy—yet still low enough not to shake either the Japanese consumer or financial markets. Japan’s 10 year government bond yield sits at 1.6%, giving investors the all-clear to keep buying stocks as long as they expect the equity market to yield higher returns than that.

That’s a low bar, one that’s easy for Japan to hurdle over. Analysts covering Nikkei 225 companies expect sales, in aggregate, to rise 3.5% annually over the next two years, according to FactSet. As long as costs don’t balloon, the growth should bring profit margins slightly higher.

Add in that Japan’s government has made changes to corporate governance standards, most notably nudging companies to bump up dividends and stock buybacks. Buybacks increase earnings per share, so analysts expect earnings per share to grow 10.5% annually for the next two years.

Such growth can push the index higher, especially because Japan has increased the tax-free investment limit in stocks. That’s unlocking more money to pour into the market—and support stock prices.

Right now, there’s roughly $9 trillion sitting in cash and cash-like investments in Japan, more than 75% of the total value of the country’s stock market. That’s a ton of cash that could be earning more—by moving into equities.

In most countries, investors hold a tiny amount of cash relative to the value of their stockholdings. In the U.S., cash is a single-digit percentage of investors’ equity holdings. The point: There’s more money that can find its way into the Japanese market.

That’s especially true because valuations aren’t so expensive. The Nikkei 225 trades at 19.9 expected EPS for the coming 12 months, its usual discount to the S&P 500’s almost 23 times.

The Nikkei’s price/earnings multiple shows that if an investor puts $19.9 into the index, the dollar of expected earnings for the coming 12 months would yield 5%, more than 3 percentage points above the yield on the 10- year Japanese bond. That compensates the investor for the added risk of buying stocks, another reason for the money waiting in the wings to push the market higher.

From Japan’s economic growth to its inflation rate to its interest rates to its heap of idle cash to its stock valuations, the case has been made—and it’s a strong one.

For those who need more money allocated outside of the S&P 500, buying the Nikkei makes sense.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com