After a near meteoric rise riding the coattails of Abenomics, the Japanese TOPIX equity index is firmly in bear market territory as domestic and global fundamentals stumble. Asia has largely been the epicenter of the latest bout of caution on the part of investors as concerns about slowing trade and diminished central bank intervention catalyzing a global equity rout that has left no stone unturned. Although the TOPIX has benefited from increased pension flows and the Central Bank’s shift into buying more equity-linked assets, the valuation is almost exclusively the derivation of weakness in the Yen. Exporters have been able to benefit from the rapid devaluation, but those gains might be coming to an end now that weakness has rapidly turned into strength. A rapid round of haven flows is likely to see the carry-trading unwind and equities lose favor among investors as valuations become challenging to justify.

Profitability Gains Transient

Japanese corporate profitability has neared record levels thanks in large part to the Yen devaluation that enabled export dependent TOPIX constituents to improve the top and bottom line significantly. However, the recent gains in the Yen may be a sign that the good times are nearing an end for exporters. Although still within the sweet spot defined by many economists as the best level for Japan to manage its competitiveness on a global stage, the incremental gains from a Yen that was substantially weaker during certain periods of the last year might be quickly given back considering current performance. In spite of record profitability however, the index recently fell into a bear market after volatility in the prior week sent shares 20% below the most recent 52-week highs in the index.

While the price-to-earnings multiple for the trailing twelve months of approximately 13.8 is very reasonable considering certain global valuations, that does not make the TOPIX index a bargain. Putting aside profitability, numerous corporate reform measures are currently being implemented across Japan, and this may see the earnings gains reversed. Furthermore, the Government and Central Bank are engaged in an ongoing battle to drive wage growth in an effort stoke inflation, a factor that may hurt the bottom line for many corporate entities. While the TOPIX should generally benefit from investment flows, namely the Japanese Government Pension Investment Fund which is increasingly forced to look outside of fixed-income for sizable enough returns, other institutional investors might be reducing exposure as volatility surges.