Why It's Time to Underweight Japan

Japanese equities have risen over 20 percent since November on expectations that a weaker yen and Prime Minister Shinzo Abe's leadership will be a game changer for the economy long dogged by slow growth and deflation, but is there is too much optimism priced into the country's stocks?

Some strategists are growing cautious on their outlook for the market, arguing that expectations for an economic turnaround are running too high and valuations no longer look as attractive.

"On a 3-to-6 month time-frame, the equity market is no longer a compelling overweight. The recent price action has become rapid and emotional," said Nicholas Ferres, investment director at Eastspring Investments, who reduced Japan stocks from overweight to neutral last week.

"Clearly the market has become overbought in the short-term," Ferres added, citing the latest global fund managers' survey by Bank of America Merill Lynch in which an increasing number of investors raised Japanese stocks to an overweight position.

Gary Evans, chief global equity strategist at HSBC, who downgraded his view on the market to underweight from neutral this week, believes investors may be placing too much hope on decisive action from the Bank of Japan (BoJ).

"We feel the excitement over 'Abenomics' is now priced in, and the Bank of Japan has yet again shown it will do nothing dramatic to end deflation," he said. HSBC forecasts the Topix Index will end the year at 900 – 3 percent lower from current levels.

Earlier this month, the central bank committed to an open-ended asset purchase program starting in 2014 and announced that it would double its inflation target to 2 percent – its boldest steps yet to inject life into the economy.

(Read More: Pressure Piles on Bank of Japan as Inflation Slips)

However, Evans said the lack of a clear time limit for the inflation target implies that policymakers remain "highly reticent" about the aggressive quantitative easing (QE) required to boost prices.

"The Bank of Japan has always been philosophically opposed to QE and monetary financing, rather like the Bundesbank," he said, referring to Germany's central bank.

The BoJ has been the least expansionary of major central banks since the 2007-2008 global financial crisis, Evans said, adding that its planned balance-sheet increase this year pales by comparison with the $1 trillion of assets that the U.S. Federal Reserve is slated to purchase.

The Japanese central bank is scheduled to buy 34 trillion yen ($374 billion) of securities under the Asset Purchase Program in 2012.

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Robert Aspin, head of equity investment strategy at Standard Chartered, agreed the market may be disappointed by the BoJ's actions.

"We have heard the BOJ and government historically talk about raising liquidity and targeting inflation, but there was very little follow up."

Aspin noted that the central bank faces a major risk in undertaking a significant amount of QE.

"If they do target aggressively the 2 percent inflation target, and undertake a significant amount of QE, that may have an impact on underlying JGB (Japanese government bond) yields as investors become concerned over Japan's debt," he said. Japan's government has among the highest debt levels in the world, with a debt-to-gross domestic product (GDP) ratio of 220 percent.

Low sovereign bond yields have long helped the government finance its debt, thus, higher yields would undermine the sustainability of its fiscal position, analysts said.

Fiscal Action Limited

While the BoJ has argued that central bank asset purchases would not work in the absence of structural reforms, strategists said that high government debt levels will constrain fiscal expansion.

"The limits of government indebtedness can surely not be pushed too much further. I am not convinced that Japan will undertake the necessary structural reform," Ferres of Eastspring Investments, said, citing the government's unwillingness to alter its immigration policies to address its aging population.

(Read More: Japan Defends Stimulus, Yen Policy Under Fire)

Earlier this month, the Japanese government unveiled a 10.3 trillion yen ($114.5 billion) stimulus package aimed at boosting growth. However, Evans of HSBC believes the impact of fiscal stimulus will be limited.

"Although the total size of the package – 10 trillion yen or 2% of GDP is large – the real impact is likely to be considerably smaller, since many of the programs have marginal benefit, for example promoting tourism in the Tohoku region, or rely on spending by local governments which are cash-strapped," he said.

Nikkei 225 6-Month Chart

Valuation Appeal

From a valuation perspective, experts added that the Japanese equity market no longer looks particularly cheap.

"Prior to the recent [rally], valuation had converged with the global average on a price-to-earnings basis. However, the rally over the past few weeks has led to a re-rating to premium levels again - Japan probably does not warrant a premium valuation," said Ferres.

The Topix carries a 12-month forward price-to-earnings ratio of 13.6, compared to 13 for the S&P 500.

For foreigners investing in Japanese stocks, the yen also poses a challenge, analysts said, with the rapid depreciation in the currency – which has fallen 14 percent against the U.S. dollar in the past three months - mitigating gains in the market.

"It is worth remembering that a government trying to weaken its currency to boost growth is a double-edged sword for foreign investors," said Evans.

Since mid-November, for example, the MSCI Japan has gained 27 percent; however, in dollar terms the Japanese index is up only 13 percent. This means that it has outperformed global equities by just 3 percent over the same time period, according to HSBC.