Nikkei at risk of falling back to 26-year low

TOKYO (Reuters) - Japan's Nikkei is at risk of falling back to a 26-year low as a deep recession and strong yen take a heavy toll on company earnings, overwhelming valuations showing shares at some of the cheapest levels on record.

Even after the Nikkei's record 42 percent tumble last year, overseas portfolio managers are likely to be slow in embracing Japan again, having dumped about a quarter of their $276 billion in stock purchases made between 2005 and 2007.

"Demand is dropping fiercely for companies," said Takashi Ito, a senior strategist at Nomura Securities.

But based on analysts' earnings expectations, Japanese shares are still more expensive than the United States and Europe despite having suffered a bigger slide than those markets.

A corporate culture where firms hold shares in each other is one reason why valuations have been historically higher in Japan than other regions.

In the business year ending in March 2010, the price-to-earnings ratio of the top 500 Japanese companies is seen at 12.25 times compared with 14.13 for the current year, according to Thomson Reuters data.

That is still higher than the 10.88 forward P/E ratio for S&P 500 companies this year, and the single-digit levels some analysts see in European indexes such as Germany's DAX

The yen's record surge last year has added to the pain from the global economic downturn for top Japanese exporters such as Toyota Motor Corp, which called the current climate an unprecedented emergency in its 70-year history.

On a trade-weighted basis, the yen soared 25 percent in 2008, shocking Japan's big companies and taking a big slice out of the value of already tumbling overseas profits.

Electronics giant Sony Corp will likely suffer an operating loss of about $1.1 billion -- its first in 14 years -- due to sluggish sales and the stronger yen, a source with knowledge of the matter said on Tuesday.

Highlighting how sharply the Nikkei slid, the price-to-book ratio -- or much much the market is valuing companies compared to the value of their net assets -- remains at just 1 after sliding to 0.87 last October when the stock index hit a low of 6,995.

Such levels are rare, indicating investors are valuing firms at less than what they could theoretically be liquidated for.

The drop to 0.87 was the lowest since 1991, according to figures from Thomson Reuters. Even during Japan's decade of economic stagnation, deflation and banking crisis, the price-to-book ratio never fell below 1.

But analysts don't think buyers will be swayed just yet.

"Unless investors can confirm the economy and corporate earnings will likely soon hit the bottom, buying based on those valuations won't take place," said Yutaka Miura, a senior technical analyst at Shinko Securities.

Miura sees the Nikkei between 6,000 and 10,000 points until March 2010, but said it may rally after that because the market tends to find a floor on average 33 months after reaching a peak. The index is now around 8,400.

The Nikkei's tight linkages to the yen also mean a stock recovery is almost impossible without a weaker Japanese currency.

The yen should hold firm below 100 to the dollar for most of 2009 as investors remain defensive in the midst of the global financial crisis, although it may weaken in the second half, a Reuters analysts' poll showed last week.

In the past year, the daily correlation between the dollar/yen exchange rate and the Nikkei is a positive 82 percent -- meaning the Nikkei almost always falls when the yen pushes higher. The yen was at 89.20 to the dollar on Tuesday, holding near its highest levels since 1995.

SLUGGISH GLOBAL REBOUND

Although analysts generally expect a global economic recovery from 2010, they say the situation will worsen before it gets better and dampen the appeal of risky assets such as stocks.

"Even if the yen softens by 10 or 20 yen, slumping demand of this abnormal magnitude has almost already decided the battle for earnings," Nomura's Ito noted.

In December, Nomura slashed its recurring profit forecasts at 400 domestic companies to a 27.5 percent drop in the business year to March from a previous estimate of a 3 percent fall, blaming the deep global economic downturn and yen surge.

Other analysts see light at the end of the tunnel for Japan's battered market.

Eiji Kinouchi, chief technical analyst at Daiwa Institute of Research, said the Obama administration's planned $775 billion in stimulus spending should spur a recovery in stocks and help boost the dollar versus the yen.

"That will better position Japanese stocks relative to their global peers going forward," Kinouchi said.

Naomi Fink, Japan macro strategist at Bank of Tokyo Mitsubishi-UFJ, forecast the Nikkei will rise to 14,000 in 2010, arguing that stocks offer a better hedge against inflation, and stronger returns than very low government bond yields.

Fink said the dividend yield on the Nikkei, after adjusting for expected inflation, was also favorable. Thomson Reuters data shows the dividend yield is 2.43 percent, nearly double the 10-year government bond yield of 1.240 percent.

Fink also expects foreign investors to return because much of last year's heavy selling was done in a forced way, such as hedge funds dumping assets to raise cash and pay off debts.

"Foreign investors are the main agents of Nikkei liquidation, and much of the deleveraging move is over."

(Graphic by Catherine Trevethan, Editing by Kim Coghill))