In late 2023, Japan's Nikkei 225 stock index rallied to its first record high since 1989. However, when viewed in U.S. dollars (USD), the index broke its 1989 record in 2021, owing to the yen (JPY) weakening from 102 per USD to 142 over the same period. Since 2021, Japanese stocks have rallied in yen terms, but the sharp fall in JPYUSD back towards 160 has led the Nikkei 225 to trade sideways in dollar terms. Viewed from a yen perspective, the index has been trading in a narrow range since late last year and remains near its 1989 peak (Figure 1).

The Nikkei 225's performance over the past 35 years stands in stark contrast to that of the S&P 500. The price return of the Nikkei 225 since December 31, 1989, has been -1.1% in yen terms and -8.6% in dollars. The S&P 500 has returned 1,586% over the same period (Figure 2). If one includes reinvested dividends, the total returns for the Nikkei 225 have been +54% in yen and +42% in USD compared to +3,331% total USD returns for the S&P 500.

Back in 1989, Japanese stocks briefly eclipsed the U.S. market in terms of market cap, accounting for about 40% of global developed market capitalization compared to 36% for the U.S. Today, the U.S. accounts for 74% of global developed market capitalization compared to less than 7% for Japan. Indeed, across a variety of valuation measures, Japanese stocks look like a bargain versus their American counterparts.

During the 1980s and 1990s, Japanese stocks paid dividends that were far lower than their American counterparts. Nikkei 225 often had dividend yields of around 0.5-1.0%. Today, the Nikkei 225 has a dividend yield of 1.84%, above what any of the major U.S. indices are currently paying (Figure 3).

The Nikkei 225 has an earnings yield (the reciprocal of price-to-earnings ratio) of 4.9%. That's higher than the S&P 500's 4.1% and much higher than that of the Nasdaq-100 or the Russell 2000, which are below 3% (Figure 4). Earnings yields are often compared to long-term bond yields. 30-year U.S. Treasuries pay a 4.6% yield; that's 0.5% higher than the S&P 500's earnings yield. By contrast, 30Y Japanese Government Bonds (JGBs) pay 2.3%, less than half the earnings yield of the Nikkei 225. This suggest that U.S. stocks could be overvalued with respect to U.S. Treasuries, while Japanese stocks could be a bargain compared to Japan's domestic bonds. Moreover, such comparisons are even more dramatic if one looks at 10Y yields, which are near 4.4% in the U.S. and only 1.06% in Japan.

Other valuation measures such as price-to-sales and price-to-book reinforce the idea that Japanese stocks are a bargain. Nikkei 225 trades at 0.96x sales (annual revenue) and 1.43x book value. For the S&P 500, these numbers are in the 3.1-5.3x range, and for the Nasdaq-100, they are in the 5.4-8.4x range (Figures 5 and 6). Only U.S. small caps compare favorably to Japan.

Japanese stocks have gone from having much higher to much lower valuation ratios than their U.S. counterparts due to major differences between the U.S. and Japan, which include the pace of growth and the kinds of firms included in the respective indices. Since 1989, Japan's real GDP has expanded by about 40%. In the U.S., real GDP has expanded by 137% over the same period.

The difference in growth can be attributed to faster population growth in the U.S. Japan's population has shrunk from 123.1 million in 1989 to 122.6 million today. Meanwhile, the U.S. has grown by 40% from 244 million to 341 million over the same period. As such, real GDP per capita in Japan has grown by 41% since 1989, while it has increased by 70% in the U.S.

That said, Japan has the world's oldest population, with a huge generation of people currently 45-55 years old about to join and an even larger group of people in retirement (Figure 7). Japan has relatively few young people who often drive innovation and growth.

The U.S., by contrast, has relative healthy demographics with a high-enough birth rate and enough immigration to support its elderly population and replace its workforce, at least for now (Figure 8).

Equity sector weights also differ between the U.S. and Japanese markets. The S&P 500 has a 32% weighting of IInformation Technology (IT) stocks, while the Nikkei 225 has a 24% weighting in this category. That said, U.S. IT stocks have vastly outperformed those of Japan in price terms in recent years.

With valuation ratios growing for U.S. stocks while shrinking for Japanese equities, it's plausible for Japanese stocks to be a strong source of diversification to a portfolio weighted towards U.S. equities, especially if they struggle to deliver the earnings investors anticipate.

One concern for Japanese stocks beyond demographics could be U.S. trade policy. Exports accounted for 16.8% of Japanese GDP in 2023, of which 18.8% went to the U.S. In other words, about 3.2% of Japanese GDP is exported to the U.S. Should the U.S. impose a 10% or 20% import tariff, that could reduce Japanese GDP by 0.3% to 0.6% and would likely hit the earnings of many of the firms in the Nikkei 225 accordingly. Sometimes, markets can react more strongly to such changes than economic fundamentals warrant.

Finally, there is the risk of the Japanese currency. USD and yen-denominated Nikkei 225 are impacted by currency movements in different ways. A weaker yen typically helps JPY-denominated Nikkei 225 by boosting the value of both exports and as well as financial and property, plant and equipment investments held abroad. From a USD perspective, however, a weaker yen usually more than negates these advantages (Figure 9).

For its part, the yen has been a rapidly moving currency and could be a continued source of volatility both for domestic and foreign investors in the Nikkei 225 (Figure 10). For a deeper analysis of the Japanese yen and its relationship with demographics and debt levels, please see our recent article.

Access the Japanese equity market efficiently with yen- and dollar-denominated Nikkei 225 futures.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.