TOKYO�Encouraged by promises of strong action by Japan's new government to weaken the yen, end deflation and introduce structural overhauls, market experts are generally bullish on Japanese equities for 2013 after the market surged nearly 20% in the last six weeks of trading.
For all of 2012, the Nikkei Stock Average rose 23%, its best performance since 2005, while the broader Topix index was up 18%. Based on projections from seven brokerages, the Topix index may add another 7% in 2013.
Politics have everything to do with the optimism: Almost all of the gains came after snap elections were called in mid-November. The new government under Prime Minister Shinzo Abe, which swept to power in a mid-December parliamentary election, is pushing the normally cautious Bank of Japan to embark on aggressive monetary easing and to set a 2% inflation target, up from 1% currently. Japan has been suffering nearly two decades of deflation; most measures of inflation are now around zero.
Expectations for greater easing have helped to push the yen lower, providing relief for the country's exporters and propelling the market higher. The yen has lost more than 8% against the dollar and more than 12% against the euro since Nov. 14 as players bet that Mr. Abe's Liberal Democratic Party would come back to power. The dollar was quoted late Monday at �86.74, its highest level in nearly 2� years.
A cheaper yen relative to the Korean won is also seen as critical because Japan and South Korea compete in key industries such as autos and electronics, making a stronger yen a big obstacle for Japanese producers.
"A weaker yen would be a powerful tool for escaping from deflation as it would improve the competitiveness of Japanese exports, leading to expanded earnings and higher share prices," said Daiwa Research strategist Kazuhiro Miyake. "The resulting upturn in consumer and corporate sentiment would enable the economy to rebound."
Hiromichi Tamura, a strategist at Nomura Securities, expects gains of at least 15% for both the Nikkei and the Topix in 2013. "With earnings at Japanese companies still about 40% below pre-financial crisis levels, there is considerable scope for recovery," said Mr. Tamura.
He expects that corporate earnings per share would rise as much as 20% from a year earlier if the dollar is at around �80, and that the gain would be 30% if the dollar rises to �90.
Strategists almost uniformly agree that Japanese shares remain undervalued and underexposed to international investors. "Japan is the only major market where price-to-book ratios still stand near 2008 crisis levels, while dividend yields are more than triple 10-year government bond yields," notes Kathy Matsui, chief equity strategist for Japan at Goldman Sachs .
With Japan currently underweight in many major international equity funds, a fundamental reweighting could potentially pour tens of billions of dollars back into Japanese stocks, she said. Foreign investors account for two-thirds or more of daily trading on the Tokyo Stock Exchange.
Aggressive easing of monetary policy by the Bank of Japan should theoretically also work to inflate asset prices�including for real estate and stocks�and fuel loan demand.
"The setting of an inflation target of 1% to 2% by the Bank of Japan should not be infeasible," said David Herro, the Chicago-based chief investment officer at Harris Associates. "Japan desperately needs to reverse its deflationary spiral, and this is the single best way to do it."
Mr. Abe has pushed for a 2% target, but the central bank has yet to act.
While aggressive monetary easing and setting higher inflation targets are relatively quick fixes, their effects alone probably won't be enough to lure the kind of foreign investor capital for needed for a longer-term recovery in equity prices, some traders say.
Structural economic overhauls are the best hope for a sustained bull market, as Japan's experience in 2005 and 2006 illustrated, said Peter Eadon-Clarke, an analyst at Macquarie Equities Research, referring to the efforts of Junichiro Koizumi, Japan's prime minister at the time. Mr. Koizumi is credited with pushing through changes to Japan's tax, regulatory and financial systems.
Some changes are already under way, including cuts to pension benefits and a staggered increase in the national consumption tax, Mr. Eadon-Clarke noted. "Politicians now have a strong incentive to introduce policies to stoke more GDP growth," he said.
This optimistic scenario has its detractors, however, including those who note that Mr. Abe's first stint as premier in 2006 lasted barely a year. Remaining in the job is difficult, making it hard for prime ministers to take radical action. The prime ministership has changed hands six times in the last six years.
Profit-taking could also stifle the market if jitters worsen over the U.S. budget, or if the LDP backtracks on key policy goals. "It's tempting to take some money off the table in stocks like Nomura Holdings that have run up so much," said Naoki Fujiwara, a fund manager at Shinkin Asset Management. "But we're standing pat on core exporters such as Toyota Motor Corp. and Canon Inc."
Adam Fisher, chief investment officer at Los Angeles-based hedge fund Commonwealth Opportunity Capital, remains skeptical. "Considering the kind of massive effort the BOJ needs to make, I'm pessimistic," Mr. Fisher said. "After so many years of merely hoping for change, I need to see follow-through before I become a believer."
Write to Brad Frischkorn at bradford.frischkorn@dowjones.com
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