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The Nikkei Gains 6.9% in 2006

The Nikkei 225 Average ended 2006 on a high note Friday, booking its fourth consecutive year of growth -- something the Japanese stock market has not seen in nearly two decades.

Boosted by advances in firms such as steel makers and auto makers, as well as increased expectations of mergers and acquisitions among Japanese firms, Tokyo stocks recovered from a steep fall earlier in 2006 to book their longest year-on-year winning streak since the years through 1989.

"For blue-chip stocks, the companies with strong earnings that are globally competitive ... it was a very good year," said Renji Motohashi, a general manager in the equity department at
Shinko Securities.

The Nikkei finished Friday's half-day of trade just a touch higher. That marked its highest close
since early May and a 6.9% gain overall for 2006.

The Tokyo market will be closed for the New Year holiday until Jan. 4, when it will open for a half-day of trade. Full-day trade resumes from Jan. 5.

Notable performers on Nikkei included Nippon Steel, which gained nearly 63% during the year, boosted by expectations of further consolidation in the steel industry. Leading exporters such as Canon also posted significant gains, rising 46% this year. Toyota Motor gained 30% in 2006.

Tokyo Stocks Set to Post Bigger Gains in 2007

In 2005, the Nikkei surged 40% to finish above 16,100, boosted by confidence that Japan's long-moribund economy was ready to post steady growth. Many market participants are betting the advance isn't over yet.

"I think investors are going to raise their Japan weighting," said Koichi Ogawa, chief portfolio manager at Daiwa SB Investments. "There's a good chance we are going to see some rebalancing in favor of Japan," he said. "It may even be happening now." Corporate earnings growth of about 10% in 2007 is likely to prompt investors to return to Japanese equities after fleeing to Europe and Asia for higher returns, Ogawa said.

Ogawa, who estimates the Nikkei could rise as high as 20,000 next year, or about 16% above Friday's close, said he expects makers of industrial electronics to benefit from increased demand from emerging economies.

Toshiba, Hitachi and Mitsubishi Electric are among the top manufacturers of industrial electronics in Japan. "I'm bullish on next year," said Jun Morita, a fund manager at Chibagin
Asset Management. "Even as investors worry about the United States, Wall Street is likely to
continue to post growth. Given that scenario, it is difficult to imagine a sell-off in Japanese stocks."

Morita, who expects the Nikkei to top the 20,000 level in 2007, said he favors blue-chip exporters and machinery stocks, as well as the country's improving banks.

Major Japanese exporters include auto makers such as Toyota Motor and Honda Motor. Leading machinery firms include Komatsu, and Kubota. Mitsubishi UFJ Financial Group and Mizuho Financial Group are Japan's two largest banks.

Down on Defensives

But defensive stocks such as pharmaceuticals, food and utilities, seen as less sensitive to economic cycles and therefore presenting a lower risk, look unlikely to extend their rally in 2007.

"This year utilities had a very strong performance but I don't think that will happen next year," said Chibagin's Morita. Food stocks, too, were unlikely to perform well, he said.

Among the Tokyo market's 33 sectors, three of the top five performers were defensives. The steel sector was the biggest gainer in 2006, rising nearly 31%. It was followed by utilities, food stocks, pharmaceuticals and makers of transport equipment.

The worst performers were consumer financial firms, retailers, airlines, construction companies and textile makers.

Steep losses in the small-cap market, triggered by a scandal at now delisted Internet firm Livedoor, helped push investors toward a more cautious tack. "After Livedoor and the small-cap sell-off, as investors became more risk-averse the number of people who started to put emphasis on valuations increased a great deal," said Akio Yoshino, a general manager at Societe Generale Asset Management.

"Next year, I think the emphasis on valuation will continue." In particular, Yoshino likes companies that tend to have a high return on equity such as steel makers and auto makers. Leading Japanese steel makers include Nippon Steel and JFE Holdings.

Yen Risk

The possibility of a stronger yen is seen as one of the biggest risks facing the Japanese equity market next year.

A strong yen is a minus for companies that make the bulk of their profits abroad, as it eats into profits when earnings from abroad are brought home. "Next year there is a relatively good chance we will see the yen strengthen," said Naoki Kamiyama, a Japan equity strategist at Morgan Stanley.

"It will become tougher to expect upward earnings revisions based on the currency rate," he said. Instead of exporters, Kamiyama favors retailers, which have underperformed this year, and banks.

Lenders are likely to benefit as Japan is expected to see higher interest rates next year, he said. "Banking is an inflationary business, so I am basically positive on them."

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